HomeFinanceCompounded interest: the 8th wonder of the world
Compounded interest: the 8th wonder of the world
June 18, 2018
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What is compounded interest?
Compounded interest simply means earning interest on reinvested interest, thus, making your interest income slowly grow exponentially over time. The key components are “interest on interest” and “time”.
Simple interest compared to compounded interest
The difference between simple interest as compared to compounded interest is that with simple interest no interested is paid on interested. This happens if you don’t reinvest your interest or earnings.
Number examples with compounded interest
Assume that you have 10K$ to invest now and that you are able to add 1K$ on your capital on a monthly basis. Assume you can make an average of 1.5% per month. This is how your earnings schedule would like from now up to 20years.
In 5 years you would have invested a total of 69K$ and earned interest of 51K$.
In 10 years you would have invested a total of 129K$ and earned interest of 261K$. Depending on your monthly need, you may reach financial independence at this point
In 15 years you would have invested a total of 189K$ and earned interest of 861K$. Welcome to the millionaires club! You will still be young enough to enjoy life.
In 20 years you would have invested a total of 289K$ and earned interest of 2.415K$. That is a whopping 970% from the investment. That averages 8.1% effective simple interest rate per month as compared to 1.5% compounded. How is that?
Number examples with simple interest
Assuming the same numbers as above: you start off with 10K$, deposit 1K per month for the next 20 years or 240 months and earn 1.5% monthly simple interest.
In 20 years, you will have invested 249K$ and earned interest totaling 466K$. That is far from becoming a multimillionaire as compared to compounded interest for the same period of time.
Simple vs Compound Interest
Let’s put the first analysis with the second analysis in one chart. Just to put things in perspective.
Do you see now why this is called a world wonder?
There is no shortcut
If you are not a millionaire already, there is really no shortcut. It required daily dedication to meet monthly saving and earnings target. Lots of creativity to come up with new ways to reinvest your additional income to achieve a compounded interest effect. The hardest thing really is to keep up with the plan. It mostly fails already by not having a plan at all. Failure is not attributable to achieving the 1.5% per month but more on the lack of discipline to simply start the journey and stay on the path. Once the journey has been started, coming up with new ways to compound money will become easier along the way. The 20 years are going to pass, one way or another. The question is: who will you be in 20 years?
There is nothing that pays interest of 1.5% per month
Taking advantage of the compounding interest effect does not mean that one is to invest in interest-bearing instruments. Besides, one will find it hard to reach 1.5% per month if all the investments are put into bonds or treasury notes or simply sit on the bank. Diversification is key. Follow one of the basic concept of the rich to have multiple streams of income. Even if you just achieve 1% per month. Compounded on a monthly basis, 1% is still as powerful. Just to give you the numbers using the same scenario above, by just changing the monthly interest rate from 1.5% to 1.0%.
In 20 years, using 1.0% per month, you will have invested 249K$ and earned interest totaling 858K$. The millionaires club still welcome you and the monthly earnings will exceed 10K. That is still enough to live a financially independent life.
We need to take taxes into consideration because taxes can half your targeted 1% to 1.5%. However, depending on which country you live in, there is usually more than one way to increases passive or active income within a beneficial and legal tax construct, meaning almost no taxes have to be paid or can be deferred to some long distanced point in the future. Taxes may drain your finances especially if you are still building and reinvesting. Consult a professional and competent tax advisor early on and become at ease with the topic. You cannot escape it, so embrace it!
Like taxes, a sound knowledge of finance and accounting is simply a must. It is the basic foundation for you to understand and control your performance or the performance of others, prepare or review your financial statements and income tax returns, analyze your business or the business of others, plan your liquidity or seek for investors or creditors. You will not need to necessarily prepare your financials yourself, but you should understand them thoroughly to gain deep insights into the result of your money making activities and where to improve.
Different ways to compounding
Besides investing in interest-bearing investment, one could invest in the following:
Invest in indexes and ETFs. Indexes and well diversified ETFs have been having a good run for the past decades. For example, the S&P did achieve an appreciation of more than 10% on average over the past 10 years. That number includes already 37% loss during the last economic crisis in 2008.
Dividend-paying stocks. Besides that good quality shares tend to appreciate in value over long times, dividends yields can go from 10 to 20% per year.
Invest in yourself. Invest in knowledge and specialized skills. Become one of the best in your field. Start earning more for your time and efforts while working for other people. Have fun doing so and your career will make regular leaps for you.
Real estate via active “buy, improve and sell” strategies or hold for rental income. The most important factor is to have a positive cash flow: Income from rent should at least equal the regular monthly payment for loan payback and interest to be paid on the loan. With every month passing by, the real estate belongs more to you, and thus, adding to your net worth and your capability to do something with the real estate portion that belongs to you. Maybe buy the next real estate?
Start a business that adds to your multiple income sources. Do you have a product in mind that other people will love? Does it solve a problem in society? If yes, you may be up to go well beyond the 1.5% per month.
Buy an existing business. Same with the real estate, you need to make sure that it has a positive cash flow on you so that it can contribute to your net wealth
There are many more examples, especially if one starts to talk details about each of the points above. Important, however, is the concept that interest and earnings are used to earn more interest and earnings. Make up your mind on who you want to be in 20 years and act today. Take advantage of the 8th world wonder: compounded interest.