25 June 2007 5 Comments Print This Post  Email This Post

Building wealth for the future is not a complex thing. What if I told you that you could be a millionaire if you have $10,000 today. It’s a reality and its made possible due to power of compounding interest. Most people think of interest as a slow paced, insignificant process because most bank savings accounts pay you peanuts each month. Its kind of discouraging seeing $2-$5 in interest paid when you get your statement. However with intelligent investing and diligent saving, you’ll see the wealth building potential that compounding interest offers.

What is compounding interest?

Compounding interest is often misunderstood, especially with the younger generation. Lets say you put $10000 into a bank’s 4 year CD at 5.2%APY . After the first year, the bank pays you $520. I believe the common mistake here is that a lot of people think that you will be getting that $520 a year for the next 4 years. However, because of compounding interest, your return actually grows year after year. The second year the bank pays you $547.04. This is because the 5.2% APY is now based on 10,520 instead of the initial $10,000. The third year the bank pays you $575.49 because the 5.2% APY is now based on $11,067.04, which is your original $10,000 plus the first year’s return of $520 and the second year’s return of $547.04. Year after year, your return is based on a higher number and it grows at an alarming rate if you give it some time.

The rule of 72

To put compounding interest into perspective, there is an awesome tool known as the rule of 72. This shows us the power of compounding interest in a simple way; doubling time. The rule basically goes as follows: You take the number 72, divide it by the annual rate of return of your investment, and you will get the approximate doubling time of your initial investment. Here are some examples:

1. From the example above, you invest $10,000 into a CD at 5.2% APY. 72 divided by 5.2 is 13.5. This means that in approximately 13 and a half years, your initial investment of $10,000 would have grown to $20,000. Wait another 13 and a half years and that $20,000 would be $40,000 assuming your interest rate is unchanged. $40,000 becomes $80,000 in another 13 and a half years.

2. Lets say you decide to start investing seriously, and you invest $20,000 into a mutual fund that has an estimated annual growth of 10% a year. 72 divided by 10 is 7.2. Assuming the mutual fund grows at 10% a year, your $20,000 will become $40,000 in approximately 7.2 years, and in another 7.2 years it will become $80,000. Another 7.2 years? $160,000. 7.2 years after that? $320,000. Finally thinking about retiring 7.2 years after that? Your initial $20,000 investment is now $640,000. Have fun!

Example number 2 shows you why Einstein called compounding interest the 8th wonder of the world. It’s truly a powerful tool that is often misunderstood and therefore goes unused. After observing compounding interest and the rule of 72, here are my two significant findings:

1. Get started as soon as possible. This could not be more important. The younger you start, the more time the interest has to compound. The later years are the most powerful ones because the numbers are much larger. If you start out too late, you might miss your money going from $500,000 to $1 Million, or (yikes) $1 Million becoming $2 Million.

Here is a graph of 20 years of compounding based on a starting amount of $20,000 and an annual rate of return of 10%. Your initial investment of $20,000 has grown to $134,550

Here is the same scenario, but now you started 10 years earlier so there is 30 years of compounding. Your initial investment of $20,000 has grown to a whopping $348,988.05. I’d rather be this guy.

2. Another significant finding with this basic concept is that your rate of return plays a huge role here. A mutual fund that grows at 10% allows your money to double twice as fast as a CD paying 5%. The difference is huge in the long run. $20,000 at 5% return for 20 years will become $53,065.95. The same $20,000 over 20 years at a 10% return? $134,550.00. Every percentage point counts in the long run, so keep that in mind.

Get started today and utilize the power of compounding interest. If you start young, you will finish rich.

Here is a handy tool that will allow you to calculate your own particular scenario. Financial Calculator.