March 24, 2015
Compound interest is an amazing thing. How can it create wealth? How can it send you to bankruptcy court?
Compound interest is an amazing thing. How can it create wealth? How can it send you to bankruptcy court?
When compound interest is working for you, you can grow your money quite well. The earlier you start investing the more time your money has to compound. The largest returns are always in the last years of an investment due to the compounding effect of the investment. If you take the rule of 72 and look at your money making 12% a year. Your investment will double every 6 years. Than the amount that was doubled will double giving you 4X the amount you started with after 12 year. Compounding also works agenst you on your debts. Your debt will also compound and grow at a quicker rate. That is why you want to pay off your debt as soon as you can if it is a higher interest rate. With the low interest rate environment of today, you may be better off only making a minimum payment if you know how to invest your money wisely.
Interest is what you are paid when you have money in a growing account. For example, “the market” rises approximately 8% a year. Do that for 3 years and you have compounded your interest if you have reinvested your gains. Using the rule of 72 you can determine the time it takes your money to double. For example if your return is 8% it will take 9 years for your money to double. This is good.
On the flip side, if you don’t pay off your credit card balance each month that will also compound. Since interest rates on credit cards are higher they will compound faster and you could end up owing much more than 2x what you initially charged on your CC in much less than 9 years.
Compounding interest helps you create wealth because it allows you to earn interest on previously earned interest.This means that when you start investing early, you have more compounding periods that will allow your money to grow.And your money will continue to grow, even if you don’t make any further contributions. On the other hand, the same is true with your debt. Outstanding debts also compound, meaning if you don’t pay them off when they are due, you will accumulate more and more debt.
Many good answers. Nice job everyone. Let’s recap.
(1) When you save consistently into low cost investments like no-load index mutual funds, that produce interest/dividends, and capital gains, this provides you the opportunity of compounding over time.
(2) When those yearly returns of 4%, 9%, 1%, 27%, etc. compound on one another, your portfolio gets big as it develops from a small pebble into a large boulder. Visualize a snowball rolling down a mountain. As it picks up snow and momentum, it becomes a much bigger snowball.
(3) The same affect can happen when someone has high interest debt payments. Credit cards are very good examples. It can send you to bankruptcy court very quickly. Choose wealth creation over wealth depletion. Financial future may follow!