“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” — Albert Einstein
I couldn’t agree more with what Einstein had to say about the Power of Compounding. In this post, I point out three things you need to understand and apply to your life to fully leverage the power of compounding to your advantage.
# 1 Compound Interest works for you or against you
Debt: If you are in credit card debt, you are paying a fortune in interest and making someone else very rich. This is the most obvious case where compounding works against you.
Inflation: You might say, I don’t have any debt. I live within my means and have enough money in my savings account. I am sorry, but I will have to burst your bubble. I don’t know of anyone who became rich by putting money in a savings account.
The best savings account these days offer a 1% APY. While your emergency funds must always be held in a saving account, anything extra must be invested.
Historically, inflation has hovered around 3%. If you have $100 today that is collecting zero interest, and you didn’t invest it, then it will have only $97 worth of purchasing power a year from now.
In this case, inflation is eating your lunch, compound interest working against you due to your inaction.
Investing: Historically, S&P 500 has provided an average return of 8% per year. You don’t need to be an investing genius. If all you did was dollar cost average and invest your money into a S&P 500 index tracking fund like VOO, IVV, or SPY, you could be averaging a 8% return per year.
You would be shocked to know that there is idle cash sitting in a lot of brokerage accounts. Just open yours and check. You may be up for a rude awakening.
If you are investing, then compound interest is working for you. This is the right place to be.
The key take away is that unless you invest, you lose!
#2 Compound Interest Works Best Over Long Periods
Sam and Mary are real good friends and 20 years old.
Sam is a saver and starts saving at age 20. He put away $1000 every year into an investment account for 5 years.
Mary realizes the importance of saving and investing much later in life. Starting at age 30, she puts away $1000 every year into an investment account for 5 years.
Let us assume that both their investments grew at an annual rate of 8%. Let us take a look at their investment balances when both of them turn 50:
Sam’s investment would come to a total of $40,177.
Mary’s investment would come to a total of $18,610.
Both of them have put in exactly $5000 into their investment accounts, however, at different points in their lives though.
Look at the impact of 10 additional years of compounding has had on Sam’s account.
The key take away is to start early in life to maximize the power of compounding.
#3 Leave Your Investment Alone
Once you have invested, don’t take your money out. Live responsibly, and do not withdraw from your investments. You have put your money to work, let it do its work for you.
A wise man earns from his capital gains, he makes his money work hard for him. Well, the unwise work hard to earn a living. Always remember that.
I learned a lot of things about money the hard way. I was in 27K of credit card debt and I took drastic measures, changed my lifestyle to get out of debt. I have been on both sides of the power of compounding. Believe me, it just feels so much better when the power of compounding works for you.
I urge you to leverage the power of compounding to work in your favor!
If you enjoyed reading this post, you might also enjoy reading the personal finance checklist.
The above was a guest post from K. Michael Srinivasan.
Author Bio: K. Michael Srinivasan, is the author of the personal finance blog Stretch A Dime, where he writes about Personal Finance, Investing, and Frugal Living. He is the author of the book “High School Money Hacks”.
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