Make Investment Bank Using the Eighth Wonder of World

I am badgering young folks (yet again) about the benefits of starting to save and invest early in life. An effective way to get this done is through the Amazing Power Of Compounding. Let's explore. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Eighth Wonders

Albert Einstein referred to compound interest as the “Eighth Wonder of the World…the most powerful force in the universe. He or she who understands it, earns it…he or she who doesn’t, pays it.” It has also been said that he occasionally combed his hair.

Equally as intriguing, Ben Franklin best described compounding as “Money making money. And the money that money makes, makes money.”That’s memorable.

Compound Interest

Compound interest can be very good to you – or not so good – depending upon whether you’re earning it or paying it.

Earning interest on reinvested money over time is a very good thing. But what about the high rate of interest you pay on that credit card…the one on which you only pay the minimum balance due? It probably feels like “the most powerful negative force in the universe.” Of course, paying interest on a compound basis is not always a bad thing. Often, in order to improve our quality of life, we need to borrow money - like when you are buying your first home.

Good vs Bad Debt

Good vs bad debt is best illustrated by the return you receive from the investment you make with borrowed money. A common example of a bad debt that can be converted to a good debt is a mortgage on the purchase of your home. Homeowners often pay as much interest on a home as the sum of money they borrow to buy the home in the first place. 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 paying off those early months and years of the mortgage as quickly as possible (simply by increasing your monthly mortgage payment), you can substantially reduce the “cost” of the original loan. And by doing so, you are no longer an investment that makes someone else rich.

Not so with credit card debt, which can also be both good and bad depending on the pleasure you derive from your various purchases and whether (or not) you pay off monthly card balances as you go.

In the final analysis, the good or the bad boils down to how (and how much) you’re paying on the debt and what you’re using the debt for.

It’s Not That Complicated

I can't emphasize enough the importance of starting to save and invest early in life. An individual, age 27, with a small amount of money can end up with a bigger portfolio in retirement than an individual who invests more but waits until his or her mid-30s to get started. Debt is hard to avoid in life, but if you typically pay interest rather than earn it, you often risk ending up paying interest on interest - compound interest - and that’s usually detrimental to your financial health.

The Rule Of 72

Thinking about compound interest can be confusing if you are math challenged like me. But there’s an old-fashioned rule of thumb tool called the Rule of 72 that folks like me use. It is a bit imprecise…but handy for on-the-spot calculations. For example, you can use the Rule of 72 to calculate how long it will take to double your investment money, given a certain interest rate.

An example:

If you are earning 5% on a $5,000 investment (72/5 = 14.4) you will double your money about every 14 years. After 42 years, your investment would double in value approximately three times: $10,000 after 14 years; $20,000 after 28 years; and $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. Either way - that’s the kind of math that impressed Einstein and Franklin…and should impress any young saver. It demonstrates the importance of tucking money into IRAs and/or 401(k)s early in life to reap the full benefit of compounding.

By the way, that same Rule of 72 can be used another way…to spot a potentially risky investment. Suppose Shyster Sam offers you an “opportunity” to double your money in three years. Divide that three-year promise into 72 (72/3=24%), which suggests that Sam is willing to pay you 24% on your investment. It may be real, but it’s more likely a scam. Twenty-four percent yields aren’t common.

In Sum

The beauty of compound interest is its “equity” attribute.

“Compound interest 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.” And he’s right. It’s simply about discipline and time. So, why not use it to your advantage…and not to your detriment." ----- John Eing, Abacus Wealth Management