Friday, 20 December 2019

The Secret And Power of Compound Interest

Power of Compound Interest

When it comes to personal finance and our journeys to financial independence and retirements. Compound interest can either be your greatest ally or your greatest enemy. 



What Is Compound Interest? 

Compound interest as I'm sure most of you know is basically just a concept that over time your money begins to make you money when the interest compounds on your principle. For example, if you had $100 invested in the stock market and it earned 10% in its first year. You would have $110. Because you made $10 in interest.

However, the same things happened in the second year and you again gained 10%, you wouldn't just make $10 because of compounding, you would actually be earning interest on a $110 in year two. And 10% of that of course, $11, so at the end of the second year, you will have $121. And just imagine how much of a difference that makes even on something as little as $100 over the course of an entire working career. 

You can see how compound interest can be a great ally. 

But it also works in Reverse. For example, if you have a lot of debts that are all accruing interests, then not only is your money not making you money, but the money that you've got when you took out the loan is actually effectively costing you money.

I'm a millennial so I'm going to use student loans as an example. Because it's been particularly prevalent for my generation.

Student loans are generally paid out over a 10-year period or 120 months, and assuming that you don't pay them off early which you definitely should, but assuming you don't, and assuming you have a fairly average interest rate which seems to hover between 4.25% depending on what time period you're looking at. 

Then year 10 from now when your loan is paid off you will have paid $9,170 in interest. That is an average of $76 a month. This doesn't sound like much but when you look at it and say okay if you had instead taken that $76 and put it into the market and averaging an 8% rate of return, you would end up with roughly around $14,000. if the money had been working for you and not against you.

I don't know about you but an extra $14,000 sounds pretty good right about now.

So yeah, compound interest is an amazing tool if you used correctly, and it can work wonders for you especially when it's combined with something like a concept of a high savings rate.


The High Saving Rate Concept.

Just as an example, let's look at Daniel and Linder.  


Daniel and Linder are both 23-year-old super savers fresh out of college. They're making $60,000 a year as a couple and live on about $2,000 a month. Now they're able to do this because they're debt-free and currently don't have any children. And as a result, they can take full advantage of their retirement plans. If They each Max out their 401ks in the first year and average 8% rate of return they will have over $600,000 waiting for them in their retirement accounts when they turn 60.

Even if they never put another penny in, for the rest of their working careers. Now if they max out their 401ks for 2 years instead of one, they will wind up with almost $1.2 million by the time they're 60. And for the record, if they were to keep working until what the government tells us retirement ages which are 67 for anyone born after 1959. That $1.2 million would grow to be over $2 million.

Considering Daniel And Linder's lifestyle even in 40 years or so, $2 million will probably be enough for them to live on comfortably in retirement. And that all happen because of just two years of saving. That is the power of compounding interest. 



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