As we close this week’s posts I add various practical thoughts and tips for dealing with compound interest in wealth creation. Enjoy.
Understand the Rule of 72. There’s an easy rule you can use to work out how your savings or investments can grow with compound interest. Just divide the interest rate (or average annual return) into 72. The result tells you how long it will take for your money to double without further savings. It can only be used for annual compounding. For example, an investment that has a 15% annual rate of return will double in 4.8 years. An investment with a 20% rate of return will double in 3.6 years. The reverse is also true: If you know you want to double your money in four years to find out the interest required you divide 72 by 4. So you will need an 18% interest rate to achieve that.
Compounding can work in your favor when it comes to your investments, but it can also work for you when making loan repayments. For example, making half your mortgage payment twice a month, rather than making the full payment once at month end, will end up cutting down your amortization period and saving you a substantial amount in interest.
By paying extra on your loans, early-on in the term, you will reduce your interest bill by a ton. In fact, with your mortgage, making a few extra payments in the beginning can knock years off the length of the loan.
There is a debate on whether to pay off your debt and avoid compound interest penalties or invest the amount elsewhere. Many people think it’s not worth your time to pay off your mortgage early since you can get a better return by investing the money. In other words, you can earn more by investing than you would save by paying off your mortgage early. Obviously this depends on both interest rates. My recommendation: when you can consistently earn more by investing than you save by paying off your debt, then its better to invest first. However if the interest on the debt is higher than the investment returns then its wiser to start by liquidating the debt first.
Get the power of compounding working for you by investing regularly and increasing the frequency of your loan repayments. Familiarizing yourself with the basic concepts of simple and compound interest will help you make better financial decisions, saving you thousands of dollars and boosting your net worth over time.