Compound interest is one of those financial terms
that gets thrown around a lot but is seldom understood. It’s like the sharpest
knife in the kitchen block. When used to your benefit, it can carve the most
beautiful masterpieces of food, but when mishandled, you can quickly cut your
hand off while trying to prepare a delectable meal.
The impact of compound interest works in two
ways.
1.) Compound
interest works for you when you are
saving and investing.
2.) Compound
interest works against you when you
are borrowing. (Not all borrowing is bad.)
So, what is compound interest? How can you better
understand it?
Let’s use Facebook as an analogy. Do you remember
when you first registered for an account? Let’s say on day one, you find 30 friends. The next day, Facebook
recommends 10 other friends you could add. Why is that? Because there was a
base connection amongst your first 30 friends, and so Facebook could go out and
find who else you might know. After two days, you have your 30 original
friends, plus 10 from the next day, which brings your friend count up to 40.
You take a few days off, and by day five, Facebook finds another 13
friends for you to connect with. Now you are up to 53 friends. By the end of
the week, you start to realize how many people you are connected to and have
met in the past. A year has now gone by, and your Facebook friend count is in
the hundreds. Why is this? Because you
made a small investment of your time and told Facebook who your friends are.
Facebook then started to help you connect with others from your past. This is
the job of Facebook, to continually help you try and find ways to grow and add
to your initial investment of connecting with friends.
While Facebook’s job is to grow your social
network, the financial market’s job is to grow your financial network and net
worth. The more connected you are to the financial markets, the greater the
value they create for you.
The expectation is that, when you put money into
the financial network, it will grow over time and at an ever-increasing
rate.
Important Words to Know
·
Principle = Money you initially invested
·
Interest = Money you earned on the principle
·
Compound Interest = Money you earned on both the principle
and previous interest earned
Short example:
You make a $100 investment. For investing that $100,
you expect a 10% rate of return. (The rate of return simply represents
the level of risk the investor is taking on.)
At the end of one year, assuming you get the 10%
rate of return, you will have $110. This is your original investment plus $10
of interest earned. You are happy that things worked out this way and so you
decide to stick with your investment. You leave all $110 invested. Again, your
investment earns 10%. This year, the 10% was earned on not just your principal
$100, but also on the $10 of interest from the previous year. So you earn $11
dollars of interest, which is 10% of $110. Add that $11 to the account, and you
have a balance of $121. If you keep up with this pattern, by year three, you
would earn $12.10 in interest, bringing your account balance to $133.10.
To recap:
· In year one,
you earned $10 in interest and have an ending balance of $110.
· In year
two, you earned $11 in interest and have an ending balance of $121.
· In year three,
you earned $12.10 in interest and have an ending balance of $133.10.
As you can see, every year you earn a bit more
interest than you did in the previous year. While it initially happens in small
increments, the magic happens when you stay with this process over decades. Let
me jump to the 10, 20, 30 and 40-year marks.
· Year 10: You
earned $23.59 in interest and have an ending balance of $259.37.
· Year 20: You
earned $61.16 in interest and have an ending balance of $672.75.
· Year 30: You
earned $158.63 in interest and have an ending balance of $1,744.94.
· Year 40: You
earned $411.44 in interest and have an ending balance of $4,525.93.
Okay, so by now, you are thinking one of two things:
“Wow, this is amazing! How do I get a piece of the action?” or, “This sounds great, but this is not what
happens in reality. This is too good to be true.” It is natural to feel
skeptical about what is really possible in the financial markets, yet I would
encourage you to know that this is how it works mathematically and in reality. I have seen the impact
personally and through the accounts of clients with whom I have worked.
However, I do have one short warning for you to
consider: there are few, if any, investments that will consistently give you a
high rate of return. What you should be thinking about as an investor is, “Over
the long run, what will my average return be?”
Two Key Assumptions
of Compound Interest
1.) When you
investment money, you should get a financial increase for the risk that you are
taking.
2.) Over time,
the financial markets will continue to grow and become more valuable.
Best of luck in continuing to grow both your social
and financial network. Give it time and some attention, and in the long run,
you will be impressed with the return on your investment.
Feel free to give me a call to talk more at 980-275-1627.
Ed Coambs
Edited by Reena Arora of Arora Media, connect on Facebook
For all your communication needs, she is all you need.
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