Compounding: The Good…the Bad…and the (Lovely) Rule of 72

From the very start of my blogging journey, I have emphasized the importance of developing the savings + investing habit at a very young age - and then maximizing your good habit by living a long and productive life!

Why (beyond the obvious)? Although a bit out of our control, longevity adds as much to the Amazing Power of Compounding as do those funds being compounded.

The great unruly-haired physicist, Albert Einstein, was said to have called compound interest the “Eighth Wonder of the World…the most powerful force in the universe.”

Ben Franklin, the kite-guy, memorably described the concept as: “Money making money. And the money that money makes, makes money.”

But the most instructive observation about compounding I’ve read is, “He who understands it, earns it…he who doesn’t, pays it."

In short, compound interest can be very beneficial – or not so beneficial – depending upon whether one is earning it or paying it.

The Good

Earning interest on reinvested money over time, particularly over a long period of time, is a good thing. But if one is paying a high rate of interest on, say, credit card purchases (e.g., paying only the minimum balance due), then the amazing power of compounding can feel like “the most powerful negative force in the universe."

However, paying interest on a compound basis is not necessarily bad. Often, to improve quality of life, one needs to borrow money. For example, borrowing money to buy that first home can be a good thing. It provides shelter, and if timed and located properly, a home can become an appreciating asset.

In fact, converting questionable borrowing into profitable borrowing is best illustrated by the return a family receives from investing in that home using borrowed money…and paying down the debt, when affordable, on an accelerated basis. It’s a fact that homeowners often pay as much interest on a home as the amount of money they originally borrowed to buy the home. How so? Traditional mortgage payments are structured such that the interest burden is heavily weighted to the early months and years of the loan. By accelerating payment of those early months and years of a mortgage as quickly as possible (or by increasing the monthly mortgage payment), a homeowner can substantially reduce the “cost” of the original loan. By doing so, they no longer have “an investment whose compounding interest is making someone else rich.”

The Bad

That’s not necessarily the case with credit card debt. This type of borrowing can be both good and bad depending on the pleasure one derives from card purchases and whether (or not) one routinely pays off the monthly card balances. The long and short of borrowing money boils down to how one is using debt…and how efficiently one is paying it off.

Debt is difficult for families to avoid, but if they collectively pay interest rather than earn it, they often risk ending up on the wrong side of compounding…paying interest on interest…and that’s usually bad.

The (Lovely) Rule of 72

It's important to save and invest early in life.

A twenty-year-old – even while earning low wages – can end up with a bigger portfolio in retirement than an individual who invested more but waited until his mid thirties to get started. .

I know, I know. Compound interest can be confusing if you’re math-challenged like me. But there’s an old-fashioned rule of thumb tool – called the Rule of 72 – that folks use for on-the-spot calculations. It helps you calculate how long it will take to double your investment money, given a certain interest rate.

Example:

If you are earning 5% on a $5,000 investment, you will double your money about every 14 years (72/5 = 14.4). After 42 years, your investment will double in value approximately three times:

• $10,000 after 14 years

• $20,000 after 28 years

• $40,000 after 42 years

(A more precise calculation using a compound interest calculator would show a value of $40,303 after 42 years, compounded quarterly).

That’s the kind of math that caught Einsteinmand Franklin’s eyes…and should capture a young saver’s attention as well. It demonstrates the importance of contributing money to an IRA and/or a 401(k) early in life to reap the full benefit of compounding. (And don’t forget to live a long time.)

By the way, that same Rule of 72 can be productively used another way…to sniff out a potentially risky investment. Suppose your cigarette smoking buddy, Slick Willie, offers you an “opportunity” to double your money in three years. Divide that three-year promise into 72 (72/3 = 24%), which insinuates that Slick will pay you 24% on your investment. It may be real, but it’s more likely a risky ruse. Twenty-four percent investment yields aren’t common.

Remember, “dare to be average…if your psyche can stand the very thought of earning “only” the S&P 500 yield. Most folks don’t.

In Sum

According to John Eing of Abacus Wealth Management, the Amazing Power Of Compounding also has an important “equity” attribute: “It does not care who you are, where you come from, or what you do, it will relentlessly work for you or ruthlessly punish you without regard.”

It’s simply about discipline and time. So, use it to your advantage…not your detriment.