“The most powerful force in the universe is compound interest.”
Albert Einstein
Big Al an Action Hero? Well perhaps that is a stretch. However, I would suggest that the gentleman who delivered the theory of relatively was certainly not a man of inaction. In fact, any decent Action Hero’s achievements rely heavily on Einstein’s work – the GPS systems they use to track their location, the laser sight on their weapons, even the digital cameras used to research their targets all rely on Einstein’s theories.
So, how about we induct him into the Action Hero Hall of Fame as an Honorary Member?
His reach didn’t end there. Not only is he recorded as saying that compound interest is the most powerful force in the universe – this from a guy working with nuclear physics, surely a pretty powerful force on its own – but he also provided us with a succinct insight into compound interest’s greatest benefit and its greatest danger with this little gem:
“Compound interest is the eighth wonder of the world.
He who understands it, earns it ... he who doesn’t ... pays it.”
To help you translate, let’s start your education on compound interest and its magical powers.
Interest on its own isn’t that interesting (pun intended). An annual interest rate of 5% on $1,000 means that, after one year, you will have your original $1,000 plus $50, or $1,050. Most of us will have some sense of that, having perhaps had a bank account that earns interest, even if only a little bit.
The magic starts the next year. Not only do we earn interest on the $1,000, we also earn interest on the extra $50 from last year. That layered effect is compounding, earning interest on your interest.
Perhaps you are still not convinced. “Peita, that means at the end of the second year I only have $1,102.50.” And you would be right. However if we travel forward 19 more years, to a total of 20 years of interest, you would have a balance of $2,653.30, from an initial amount of only $1,000. If this doesn’t toot your horn, add a few zeros to the starting amount: $100,000 will grow to $265,330 over 20 years with a 5% interest rate paid.
This is all from investing a single amount.
Think of it like a snowball that starts the size of a tennis ball at the top of the hill; however, as it rolls down the slope it picks up bits of snow at an ever increasing pace until you have a snowball the size of a house.
The other key element of interest on interest is the higher the interest rate the bigger the wow factor. At a 10% interest rate, our $100,000 becomes $672,750 in 20 years. The higher interest rate gives you an extra $400,000 from the same initial investment of $100,000.
So, those are the basics of compound interest – earning interest on your interest.
While this is great, it is, in fact, not the true extent of the magic. I imagine very few of you have a lazy $100,000, or perhaps even a lazy $1,000, lying around to invest and watch it grow.
The Good
The good stuff for most of us is experienced when we regularly put money away somewhere that earns interest.
So, let’s say you decide that you are going to put away $5,000 now, followed by $5,000 at the end of every year for 5 years. You are starting from zero, but you are still starting, so kudos! Going back to our original 5% interest rate, after investing $5,000 upfront followed by another $5,000 every year for the next five years you would have $34,010.
To step you through this:
You invest: $5,000 x 6 = $30,000
You earn interest (over the 5 years): $4,010
Total balance (at the end of 5 years) = $34,010
Keep it up and, after 10 years, you would have $71,034.
And if you managed to continue that for a total of 20 years? $178,596 buckaroos would be yours.
This is what makes regular contributions into your retirement or superannuation account so effective. If you were to start at age 25 and be contributing the $5,000 into your retirement fund every year until you turned 65, then you would accumulate over $600,000 at a 5% interest rate. If you manage to get a return of 10% over that time, the figure you retire on becomes more like $2.4 million.
Hooley, dooley. If that ain’t magic, nothing is.
Let’s just take another look at those numbers. $5,000 a year,
10% interest,
40 years ...
$2.4 million
The secret to all of this, the most important thing to take away?
Interest + Time = Money
Keep revisiting this until that sinks in because it is the secret weapon behind every Finance Action Hero.
The Bad
The bad news is that the longer you wait to get started, the less time you have to see the effects and, therefore, the smaller the amount of money you will earn.
So let’s go back to our 25-year-old. They decide that 25 is too early to start saving for retirement, they are going to wait until they are 35 to start putting the $5,000 away. At age 65, they manage to accumulate about $900,000 (at a 10% interest rate). Not a small sum I’ll grant you, but a tidy drop from $2.4 million.
If that same 25 year old then puts saving off until they are 45? They will have accumulated just $320,000 by age 65.
What a difference.
Somehow I have managed to pack a number of clever quotes into this rule, however if you will indulge me just one more, this Chinese proverb captures this concept perfectly:
“The best time to plant a tree is twenty years ago. The second best time is now.”
So don’t feel disheartened if you are a little older than 25, or even older than 45. The important lesson is to take action NOW. Be a Finance Action Hero and get that compound interest working for you.
The Ugly
Unfortunately, the power of compound interest can also work against you.
Anyone who has ever had a mortgage will have experienced this. That layer-upon-layer effect also causes the cost of borrowing money to be massive.
Let’s start with a $200,000 mortgage over 30 years. This is going to sound a little ridiculous to the Sydneysiders reading this as the average new mortgage in Sydney ticked over $500,000 in 2013. However, this is simply an example.
In repaying the $200,000 over 30 years, at a mortgage rate of our magical 5%, your repayments will be about $1,100 a month.
To make sure I am not making massive leaps in assumptions here: X You borrow: $200,000 over 30 years
You repay: $1,010 a month or 12 x 30 x $1,010 = $363,600 in total payments
Total interest paid = $363,600 - $200,000 = $163,600
This means that you will have paid back not only the original $200,000, but have also paid a total of $163,000 in interest.
Wait a second? Paying back a mortgage of $200,000 costs you $363,000?
Yup, unfortunately it does. And it gets worse – if the interest rate is more like 7.5% then the total you pay back on a loan of $200,000 is over $500,000. Which makes the interest you pay on the loan more than you borrowed in the first place.
And that, my friends, is the sad side of the power of compounding interest. Any debt you have has this problem.
Not wanting to throw napalm on the fire, but now that the downside of debt and interest is clear, have a think about the interest you are currently paying on your credit cards. These interest rates can be as high as 25%. Imagine the damage compound interest can do at that rate ... ?
Let’s just revisit what we’ve learnt about interest so far:
Save regularly
Start early
Long term debt costs a bundle