ITS LIKE A GUARANTEED LOTTO WIN
$700 per year… or $230,000?
$500 per month… or $1.3 million?
… the magic combination of compound interest and time.
Leaving aside inheriting or winning at lotto (good luck with that) what wealthy people know is that there are two main ways to generate significant wealth.
The first is to ‘create a capital event’. This means selling something highly valuable, a business you have built up or real estate you have developed or renovated (and don’t need to live in). This approach demands great focus and usually a lot of risk.
The other way uses the incredible power of compound interest and only requires patient persistence.
What is the power of compound interest? Simply put, it’s earning interest on interest. The magic ingredient is time.
Here’s a really simple example.
Assume you have $10,000 invested, earning 7% p.a.* and every Christmas you withdraw the year’s interest and buy yourself a $700 present. After 5 years or 45 years you will still have $10,000 in your account. Let’s say, though, that you forgot about the investment, leaving it to earn interest on interest. After 5 years, there would be $14,176 in the account. (Good, but not really exciting?) After 45 years of foregoing that $700 per year ‘selfie present’ there would be $231,235 in the account. That’s the power of compound interest.
Here’s a more realistic example.
Instead of upgrading your car regularly, paying a $500 per month lease, imagine you drove the car you could afford to buy with cash (or skipped the car entirely) and locked that money away every month in an interest earning investment, at 7% p.a. Now watch what happens to your investment over time.
|
Savings |
Total Interest Earned |
Your Wealth |
|
| Year 1 |
$6,000 |
$196 |
$6,196 |
| Year 5 |
$30,000 |
$5,796 |
$35,796 |
| Year 10 |
$60,000 |
$20,542 |
$86,542 |
| Year 20 |
$120,000 |
$140,463 |
$260,463 |
| Year 30 |
$180,000 |
$429,985 |
$609,985 |
| Year 40 |
$240,000 |
$1,072,407 |
$1,312,407 |
Notice what happens by the 20 year mark? Your total interest earned is more than the amount you’ve deposited. By 30 years it’s more than double and by 40 years it’s nearly 4.5 times. That’s the power of compound interest. And it doesn’t require a lifetime of sacrifice to risky, demanding business ventures or real estate developments.
All it requires is that you start early (even in a small way), and apply patience.
So what does this really mean, in practical terms? It all comes back to time.
- The most powerful savings and investment decision you can make, is start now.
- The second most powerful thing you can do, is keep at it. Lots of small steps will take you to the same place as a massive leap.
- Compound interest works against you when you borrow – so any thing you can do to repay your borrowings faster will be the same as an investment that takes advantage of compound interest.
* What’s with the 7% p.a.? How can you get that return? No bank is offering anywhere near that sort of interest rate, of course, but investors consider it a reasonable expectation for long term average returns from a portfolio of investments including shares, deposits and property. To find out how to achieve this sort of return over the long term, talk to a financial adviser.
What are your thoughts?
Are you impressed by the sheer power of compound interest over time? Did we leave anything out? Is there anything else you’d like to know about long term saving? Do you have any other investment questions?
Join the conversation — leave a comment below and let us know what you’re thoughts are.
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