I have recently finished reading Tony Robbins’s book Money: Master The Game. I highly recommend it. He makes a passionate appeal for people to understand compound interest and its impact on one’s wealth creation strategy. So this week lets take a look at this concept.
Interest is a powerful thing. When you borrow money, you pay interest. When you lend money, you earn interest.Interest is defined as the cost of borrowing money, and depending on how it is calculated, can be classified as simple or compound interest. Simple interest is calculated only on the principal amount of a loan.
Interest compounds. Starting with the principal, after interest is calculated and paid, it is added to the original amount to make a new larger principal. Compound interest is calculated on the principal amount and also on the accumulated interest of previous periods, and can thus be regarded as “interest on interest.” This larger principal now garners slightly more interest, and so on … This compounding effect can make a big difference in the amount of interest payable on a loan if interest is calculated on a compound rather than simple basis.
In the words of Ben Franklin: “The money that money earns, earns money”
On the positive side, the magic of compounding can work to your advantage when it comes to your investments, and can be a potent factor in wealth creation. While simple and compound interest are basic financial concepts, becoming thoroughly familiar with them will help you make better decisions when taking out a loan or making investments, which may save you thousands of dollars over the long term.
Compound interest is a double-edged sword. It’s great if you’re saving money but it can be cruel if you’re borrowing money. You can collect interest due to compound interest or you can suffer from paying compound interest depending on whether you invest or borrow.
You want savings to compound as often as possible. It’s better if you compound quarterly rather than annually when you’re saving money. If you’re borrowing, just the opposite applies.
Time is on your side. The longer money compounds, the faster it grows. Money growing at 6 percent per year will double in about 12 years, but it will be worth four times as much in 24 years.
Time is not on your side. Be careful about credit cards and mortgages as they use compound interest against you. It is wiser to always pay slightly more than the minimum repayment required so that you constantly reduce the capital amount. This reduces the compound interest that you repay. Suppose your interest rate is 14 percent and you add just $5 per month to your payment. In 10 years, you would have saved $1,315 in repayments. My family used this method way back in 2001-2005. We borrowed several million dollars (by the way did I say it was Zim Dollars) to buy a commercial property. It was a 15 year mortgage. We decided to pay more than the required amount and within 5 years we had paid off the mortgage and saved ourselves millions of dollars worth in interest repayments. Obviously the bank was not happy and they charged us a penalty. But this was nothing compared to the savings.
Time is either on your side or against you. Compound interest supercharges your savings because you earn interest on the interest you earn as well as the money you deposit. The longer you leave your money, the more powerful the compound interest effect. The longer you leave your money, the more powerful the compound interest effect. So the earlier you start saving, the more you will make from compound interest (but only if you don’t withdraw the interest). The same applies to other investments such as shares, where you regularly reinvest dividends, or the company reinvests its profits.
Compound interest simply means to REINVEST your investment return into your total investment amount. Total investment amount is called PRINCIPAL in personal finance. Your principal grows exponentially with the compound interest, that is how the magic works and that’s why we like to say it is powerful.
Compound interest can be your friend or your enemy. When it applies to debt it’s a wealth eroder. The longer you leave a debt which charges interest, the bigger the debt becomes. Compound interest works against you through either mortgage debt or consumer debt. At one time we took a mortgage to finance a company we owned. The company paid the mortgage faithfully for a few years and later inconsistently during a tough time. When we had to bail the company out 5 years it had paid over $150 000 but the outstanding balance was still $293 000 out of a $300 000 -10 year mortgage. I was so disappointed. Compound interest had worked against me and in favour of the bank. When I took over I undertook to pay more than the required amount and consistently so as to reduce the effect of compound interest working against me.
Compound Interest is really interesting interest that you should show interest in. It can either build you or destroy you along the wealth creation journey.