What is Compounding ?
If you want to reach Financial Freedom , you MUST learn the importance of compound interest.
It is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
Example: 1,000$ is deposited into a savings account paying 20% per annum, compounded annually. At the end of one year, 1,000 x 20% = 200$ interest is credited to the account. The account then earns 1,200 x 20% = 240$ in the second year. And so on….
Compound interest is contrasted with simple interest, where previously accumulated interest is not added to the principal amount of the current period, so there is no compounding.
Compound Interest : Friend or Foe?
It is so important because of the very powerful effect it can have on your financial situation over time.
As J. Reuben Clark said “Interest never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels . . . it has no love, no sympathy; it is as hard and soulless as a granite cliff.”
When working for you, compounded interest can help you create enormous wealth.
It is because of this extraordinary power of compound interest that it is important to start investing as soon as possible and as much as possible.
Those who start investing when they are young will have an immense advantage compared to those who start investing in old age, as time plays an extremely important role.
So, for example, if you start investing only $ 100 a month for your retirement from the age of 20 and invest that amount for 40 years, with an average annual rate of return of 10%, then you will have the incredible sum of money of $ 588,748!
A compound interest that works against you can have a devastating effect on your finances and your life.
Be very careful: this type of compound interest is often associated with credit card debt.
Quoting once again J. Reuben Clark, he said: “Once in debt, interest is your companion every minute of the day and night; you cannot shun it or slip away from it; you cannot dismiss it; it yields neither to entreaties, demands nor orders; and whenever you get in its way or cross its course or fail to meet its demands, it crushes you. “
If you have a compound interest debt, pay off the debt as soon as possible, whatever it costs. You will not regret.
How can I benefit of compound interest?
Investing is not only a question of how much money you have saved and how much you need to invest, but it is also about the time of your investment plan.
First of all you have to ask yourself: how long do I want to invest?
This is a question of fundamental importance because of the incredible power of compound growth.
Compound interest makes your money grow faster because interest is calculated on the interest accumulated over time and on the initial capital.
Compounding can create a snowball effect, as the original investments plus the revenue earned from these investments grow together. More time, more growth potential.
The following table (source Scwab Moneywise) shows a concrete example of compounding power.
As you can see, investor 1, who started at the age of 18 but invested for 10 years only, accumulated more at investor 2’s pension, who invested for 25 years. However, investor 3, who invested 18 to 67 years, has accumulated significantly more of both.
so don’t underestimate the combined power of time and compound interest.
Instead, master its beautiful mechanism and learn how to use it to your advantage.