| I remember when I was a kid, and I first heard about | | | | money into my retirement account that she doesn't |
| compounding. I had a passbook savings account with | | | | want me to touch until I am 75 years old. I have no |
| the standard rate of 5%. My mom and I were talking | | | | clue what retirement is and I really would prefer just |
| about how the savings would grow. I said, "so every | | | | buying a bicycle but she is my mom, so I go along with |
| year I am going to get $5 on my $100" "No," she said, | | | | it. Mom invests the $100 into the super low cost |
| "Its going to be more than $5 because you are going | | | | Vanguard S&P 500 Index fund and they waive |
| to get interest on the interest". I didn't understand this | | | | the minimum for her since she offers to bake them |
| for a long time and it all seemed very confusing, why | | | | some cookies (Vanguard just opened its doors a few |
| couldn't it just be $5 and make it easier. | | | | years earlier so they are very welcoming). Can you |
| Thankfully for all of us investors, that $5 ends up being | | | | guess what that $100 would grow into 65 years later if |
| a little bit more due to compound interest. Read More | | | | the average return of the fund is 10% over that time? |
| Simple interest is simple, but compound interest is | | | | Almost $49,000. That's the magic of compounding. |
| God's gift to investors and the Devil's reward for | | | | Compare that to investing in a "65 Year CD" at 5.00% |
| debtors. It still amazes me how many people still don't | | | | where I would end up with about $2,300. Nice, but I am |
| fully grasp the power of compound interest. If you are | | | | guessing I would go with the bike over the CD. |
| going to be a cheap person, you better get fully | | | | But compounding also works when it comes to debt. |
| acquainted with it and make it your friend. | | | | Sorry Charlie, but the banks want interest on interest if |
| First, let's look at simple interest. You have a $100 and | | | | you don't pay it. Perhaps you remember an evil little |
| you earn a 5% interest rate, after a year, you have | | | | mortgage called the option payment, pick a payment, |
| $105. After two you have $110. Pretty simple. Now if | | | | or negative amortization loan. It only had a brief lifespan |
| our compounding period is a year, after 1 year of | | | | originating in 2004 and rightfully going extinct just 3 |
| compounding, you have $105. But after two years you | | | | years later. This mortgage let borrowers pay less than |
| have $105 plus $5.25 for a total of $110.25. OK, so its | | | | the fully amortized interest. Meaning that their principal |
| different but you might be saying, 'What's the big deal, | | | | balance would grow compounded until it hit a ceiling at |
| its almost the same' and for two years, you would be | | | | which time the borrowers would have to pay the |
| right. | | | | much larger payments. Needless to say, very few |
| Thankfully, we tend to live, invest, and unfortunately | | | | borrowers of these loans ever paid them back and |
| borrow for more than two years. Let's take our same | | | | the institutions that created them are now gone. |
| example again but this time for 10 years. If we had | | | | The balance on home equity lines of credit can grow |
| simple interest, this is easy 5%*$100*10= $50 so we | | | | rapidly due to compounding as can your credit cards. |
| would have $150 in our account. For compound | | | | Credit cards are the worst because they have such |
| interest it's a little harder to calculate. If we express our | | | | high interest rates. Imagine how much money you |
| $105 relative to the original $100, its 105% or 1.05. Now | | | | would have if you were earning an 18% interest rate, |
| we get to the real math part. If we compound that for | | | | let's just say that $100 that you invested at age 10 |
| 10 years it would be expressed as | | | | would be all that you need for retirement. And |
| 1.05*1.05*1.05*1.05*1.05*1.05*1.05*1.05*1.05*1.05 = 1.629 or | | | | remember there are some people paying the banks |
| said another way, after 10 years of compounding we | | | | 29.99% and they wonder why they can't keep up. |
| are going to have $162.90. Now you see how big the | | | | But let us say, you had virtually unlimited credit. Perhaps |
| difference can be since we have nearly $13 more | | | | if you were the United States Government. Our |
| than if we just had simple interest. | | | | current interest bearing debt is $11 trillion. Assume that |
| If you want a quick way to calculate the effects of | | | | we manage to not run any more deficits by selling |
| compounding learn to use the rule of 72. What that | | | | things like the Grand Canyon, Yosemite National Park, |
| rule tells you is that if you're getting 10% interest, your | | | | and Alaska to the Chinese. Furthermore, let's just |
| money will double in 7.2 years. And if you're getting | | | | assume that in order to not incur any more debt the |
| 7.2% interest you'll double your money in 10 years. So, | | | | Chinese give us the pick a payment plan and we pick |
| the math is relatively easy, just divide 72 by whatever | | | | zero and they charge us 5% interest for the privilege. |
| interest rate you're getting and you'll get a good idea | | | | What would this $11 trillion turn into in 50 years if we |
| of how long it will take for your money to double. If | | | | made no net payments on it? Just $115 trillion. |
| you're getting 9% interest, your money will double in 8 | | | | According to a report from BCG, North America today |
| years, but if you're getting 8%, it will take 9 years to | | | | is worth $29 trillion. The problem we have is that the |
| double. Now the rule of 72 works doesn't work for all | | | | United States won't be worth $115 trillion unless we |
| interest rates. If you're getting 72% - it obviously will | | | | massively inflate our currency. |
| give you some false reading. But then again, you won't | | | | So unfortunately, you own a piece of this debt which is |
| have to worry about being cheap if you're getting that | | | | compounding away every day. Hopefully you have |
| rate of growth for more than a few years. For typical | | | | enough assets that can offset your share. |
| interest rates, in the 4% to 18% range, it works fairly | | | | Compounding, it's your best friend as an investor and |
| well. | | | | your worst enemy as a borrower. When you are |
| We used a passbook savings account example with | | | | earning it on your cash time is on your side. When you |
| 5% and a 10 year time horizon. Let's look at something | | | | are a borrower you despise every month that you |
| a little more interesting like your retirement. Instead of a | | | | need to fork over an increasing amount of your hard |
| $100 in a passbook savings account, my mom decides | | | | earned dollars. Be Cheap, make compounding work |
| that at the ripe old age of 10, that she is going to put | | | | for you. |