Updated: Jul 8, 2019
Welcome, Money Talkers! So today, I want to talk about a more complex topic than you are used to. You might tune this out from the beginning because of the math involved, and maybe you find the topic boring… but I GUARANTEE you that this concept is something that you want to know about if you want to increase your net worth.
So without further adieu, this week’s topic is the magic of compounding!
So What Exactly Is Compounding?
Compounding is one of the most important terms for anyone who is trying to improve their personal finances to understand. It’s a way to potentially increase your savings, just by keeping your money in the right place. Compounding occurs when an asset's earnings are reinvested to generate additional earnings over time. This growth happens because the investment will generate earnings from both its initial principal and the accumulated earnings. So let’s say you invest $1,000 with an annual interest rate of 10%. After the first year your principle, $1,000, will have earned $100 in interest. The second-year your principle of $1,000 plus the interest you earned the year before of $100 will earn $110 in interest. And so on and so forth. This might not seem like much, but over time this exponential growth can really start to add up.
What Does Compounding Mean For You?
Compound interest works on both assets and liabilities. An asset is something that makes you money and a liability is something that you lose money on. In other words, it can work for you or against you. It’s how you use it that matters. Understanding how compound interest works is essential. As Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it earns it, and he who doesn’t pays it.”
Compounding can increase the amount of interest owed on borrowed money as interest accumulates on the unpaid principal and previous interest charges.
Whenever you borrow money, you pay for the privilege. A lender expects to be compensated for the use of its capital. This compensation comes in the form of charging simple interest on the amount you borrow. Compound interest, though, is interest charged on your interest.
Credit cards are one of the most common ways that compound interest works against you. This is because the compounding is likely to take place more subtly.
Unlike regular loans, where you borrow a large amount of money and are painfully aware of the big risk your taking, credit card debt can sneak up on you. You think you will just use a little bit here and a little bit there and pay off the balance at the end of the month. But more often than not, credit card users carry over a balance to the next month. It may start off as a small amount, but with the temptation to borrow and the money literally at your fingertips, your balance can grow rapidly.
According to Experian's latest State of Credit report, the average U.S. consumer holds about two bank-issued credit cards and carries a total balance of $5,551. That's a lot of money, especially if you have a high-interest rate. So let’s make the lower end of that spectrum an example. Let’s say your balance is $5,000, with an interest rate of 15%, and you only pay only the minimum payment of 2% monthly (which many people do only pay the minimum). At that rate, it would take you 24.9 years to pay off the loan, with 299 monthly payments, and the total interest charged on the principal amount of $5,000 would be $4,696.61. You would end up paying almost exactly the amount borrowed in interest alone. That’s CRAZY! That is the power of compounding when it’s against you.
Compounding can rapidly boost the value of an asset because interest is being paid repeatedly. The first one or two cycles are not especially impressive, but things start to pick up after you add interest over and over again. Whether it’s a savings account, investing for retirement, or investing in the stock market, compound interest can propel a meager principal into exorbitant sized earrings overtime.
Savings and Investing:
Compounding with savings accounts and investments in the stock market are similar. Your interest earns interest, so you make more. The only difference is the interest rates. Savings accounts interest rates are usually anywhere between .01% and 2.52%, whereas, an investment in the stock market averages 10% annually. The higher the risk, the higher the reward, and the more compounding that can occur.
It's a snowball effect in which the first few years of not-so-impressive returns may not excite you, but as you get further on down the line, it turns into real gains.
Many certified financial advisors suggest that investors use the Rule of 72 to figure out just how quickly compounding can work. The Rule of 72 is a simple way to determine how long an investment will take to double given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors obtain a rough estimate of how many years it will take for the initial investment to duplicate itself. If your investment has a 6% average annual growth rate, the Rule of 72 indicates that it should take about a dozen years for that investment to double. When you're talking about compounding, you have to have a long-term time horizon.
Investing For Retirement:
The magic of compounding can be a powerful tool to build your retirement savings. There are two main types of traditional tax-advantaged retirement investment accounts, IRA and 401(K). The magic of compounding when saving for retirement is that time is on your side and your money grows tax-advantaged.
With an IRA, the maximum contribution for 2019 is $6,000. If I opened an IRA with an annual interest rate of 6% when I was 25 and I maxed it out every year, in forty years when I hit retirement age I should have $1,273,366. Now just so you realize the magnitude of compounding interest, without interest or compounding interest, the principal contribution alone was only $240,000. However, the end result of the $240,000 I invested for retirement in my IRA accrued $1,033,366 in interest and compound interest. Plus, your money is in a tax-advantaged account. There is no tax deduction for contributions made to an IRA so you have to pay taxes on that money before it goes in, however, all future earnings are sheltered from taxes. An IRA provides truly tax-free growth.
A 401(K) has two main differences from an IRA. The first main difference is its tax-advantage. With a 401(K) you put the money in without paying taxes on it and you only pay taxes on it when you withdraw it, instead of the other way around. The other difference is the employer contribution that might be available with some 401(K)’s. Some employers offer a match, so if you contribute a certain percentage of your paycheck they will match your contribution up to a certain amount. So on top of the tax advantage, the simple interest, and the compound interest, you have “free money” from your employers’ contribution match as well. So if we take the same exact example from above with the Roth IRA and add an employer match contribution of 3% (which is the national average) then instead of having $1,273,366 after contributing $6,000 annually for forty years we will have $1,527,812. So this account earned a whole extra $254,446 of free money, just for opting into your employer match contribution. That’s nuts! So if your employer offers a match, always contribute at least up to the match, its FREE MONEY!
How Can You Make Sure Compounding Works In Your Favor?
So now that you know how compounding works with liabilities and assets, how can you make sure you are getting the most out of compounding? Here are some helpful tips:
Pay Off Debt Quickly: The longer your debt sits there, the more compound interest it will accrue, the higher your balance will become, and the more you will have to pay in the long run. Do not allow yourself to be a slave to debt. Always pay more than the minimum monthly payment amount and do not borrow what you cannot payback.
Keep Borrowing Rates Low: The interest rates on your loans determine how quickly your debt grows, and the time it takes to pay it off. See if it makes sense to consolidate debts and lower your interest rates while you pay off debt.
Start Saving Early: Compounding is more dramatic over long periods. The longer your money's earning interest, the more times interest will be calculated and compound.
Check APY: Make sure your savings account has a good interest rate: Interest rate is a very important factor in your account balance over time. Higher interest rates mean your money will grow faster.
Contribute Often: The more you contribute to your savings, retirement, and investment accounts, the more money that will earn simple interest and compound interest.
Over time, compound interest really adds up. It is up to you if it will be working against you or for you.
Make smart choices. Try not to borrow, pay off debts quickly, save in a high yield savings account, invest in a tax-advantaged account, always match your employers’ contribution, invest early and often, and watch the magic of compounding grow your wealth right before your eyes.