AN ODE TO COMPOUND INTEREST
“Oh Baby I love the way you make my paper stack.. I invest it, it doubles maybe triples and you bring it right back. Compound Interest what can i say, you a real life hack ima talk about you all day.”
Compound interest is truly one of the amazing things in this capitalist society. Albert Einstein once called it the eighth wonder of the world because when used in your favor compound interest takes a little money you've saved up and turns it into big money you can make moves with, it’s the single most viable tool for growing wealth ever to exist. Compound interest is when you earn interest on both the money you've saved and the interest you earn. Essentially interest multiplied on interest. The mathematical formula for calculating compound interest,
A=P(1+r/n)^nt,
A = final amount
P = initial principal balance
r = interest rate
n = number of times interest applied per time period
t = number of time periods elapsed
Calculated based on both the initial principal and the accumulated interest from previous periods. The compounding schedule interest can accrue on anywhere from a daily weekly monthly semi annual to annual basis. you earn returns on the money you invest as well as on returns at the end of every compounding period. If you don’t feel like going through the mathematics here’s a link to a compound interest calculator
If you ever wondered how your 401k retirement pension or even your insurance policy makes you money while you sleep outside of your contributions. It is because of compound interest. Anything that offers a rate of return can provide compound interest. However the actual rate of return is very important. Many Banks offer savings accounts with a percentage rate of return.(national average right now is .05%) But often that rate is so low that even after years of compounding you won’t see much of a difference. Also important when looking to take advantage of compound interest is the time horizon. Compound interest is Better for young people because they have more time to take advantage of the compounded growth rate. A 25-year-old who started investing $200 per month (assuming a 6% return), by the time they turned 65, would have a nest egg worth $393,700. But if they’d waited until 35 to start saving $200 a month, even with the same rate of return, they’d end up with almost half that $201,100 by age 65. Without the effects of compound interest the 200 dollars saved every month from age 25-65 would only amount to 96,000 which as you can see is a partial amount compared to the compounded return of 6% annually. Earnings from compound interest are taxable, unless the money is in a tax-sheltered account like a retirement account (401K IRA ROTH IRA ETC)
Now let me ask you something. Why do you have so much money sitting in cash in a bank account? Are you preparing for a big purchase and need to put the funds into escrow? You might say it’s for an emergency but I want you to really think what kind of emergency would happen that would require you to need more than 2 thousand dollars in one day? Wouldn’t that money be better served accumulating a decent annual return through some investment? People sometimes believe that investing money puts that money outside of their reach for an extended period of time and for some investments like real estate that might be the case. With securities like a stock however you can sell and receive the value in cash in just two days it takes the trade to settle. Some brokerages let you have access to the fund immediately. At BAGlobal Capital we preach the importance of an emergency fund because things happen but outside of that you should consider putting more funds into your investments. As a millennial myself I understand the need to want to have cash on hand to cover immediate expenses versus saving for your future but I put away anyway because I also understand that because I am younger I have more time to take advantage of compound interest. In fact in many cases its more efficient to save small amounts while you’re younger vs trying to save a lot at once when you’re older.
Compound interest benefits investors, but the meaning of investors can be quite broad. Compound interest works against you when you borrow money, whether that's via student loans, car loans, mortgages, or credit cards. I point this out because it is important to understand the kind of interest you take on when you sign up for these kinds of loans. Just as compound interest is great when its accumulating in your favor it can be devastating if its working against you.
Ill leave you with this. The other night when i was writing this blog post. A neon sign i had in my house caught on fire around 5am. If i hadnt been awake writing this who knows what could have happened. Compound interest literally saved my life!
Remember I may be a financial advisor but I’m not your financial advisor. Nothing in this blog post should be considered financial advice. If you have any questions or would just like to discuss how to improve your financial wellness please feel free to contact me.