How to Compound Interest

What is Compound Interest?

Compound Interest is when the interest payments on an investment asset are added to that interest earning asset every time interest is paid. The result of this action is that your interest earns interest every time interest is paid in the future. It is the most powerful tool for building wealth. It is also the most passive and most effective way a busy modern person can improve their personal financial position. With just a little will power anyone can and should use this tool. What is amazing is that most people do not use this tool to benefit their personal finances.


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There are 2 facets to earning compound interest. First is the concept that you earn interest on your interest. The second is what I call compound savings. This is where you run your budget to spend less than you make and thus save some money every month. You add this to your savings asset which is already earning compound interest. This means you add to your interest earnings in 2 ways. You immediately start earning interest on the savings from your budget surplus and you earn interest on what you have already saved.





How does Compound Interest work?

The best way to answer this question is to show you an example. Below is a compound interest table using the example of $100 saved every month at 5% interest for 25 years. You can click on it and it will open in another window so that you can see it more clearly and follow the concepts presented below. Note the sidebar remarks in this compound interest chart. You see the power of saving $100 per month through your saving contribution from your budget surplus. You see the power of compound interest to double your money as well as many other milestones we identify in a 25 year savings journey.




Compound interest is your best friend or your worst enemy. It is interesting because the choice is 100% yours. It is as personal a choice as you can make in personal finance and folks overwhelmingly choose that it be their worst enemy. They choose to overspend and then pay have to budget to pay credit card debt at high interest rates. So that you can make better choices let us explore how compound interest can be analyzed and then managed using your personal budget, balance sheet and life plan. Apply these concepts to your personal finances and get the most powerful financial tool known to man working in a positive way for you!


The very start of the compound interest cycle is that you have to start saving money from your budget. That means you have to make a special entry on your budget and save some money. Put some money into an interest earning investment product. You can do this by saving money out of each paycheck or by putting aside a windfall that you have been blessed to receive. Once you have done that you can see how to make your money work for you from the chart above or have some fun with the calculator included on this page. As identified on the chart you can see that you actually increase your monthly income by earning interest which increases your monthly budget surplus.


This gives you an asset on your balance sheet. The goal in your financial early life is to grow this asset. All of the interest you earn is put back into the asset. You can do this in 2 ways. You can take a regular savings interest payment and reinvest it yourself into different investment products. Or you can buy an interest or dividend reinvestment product. In the latter, the income from your investment is automatically reinvested in your product resulting in you owning more and more of that product over time. Either way you make your money work for you with compounded returns on your investment.


The interest that you earn and put back into the asset is actually income on your budget. It should not affect your monthly consumer spending until you use it for dire emergencies or retirement. Keep your budget within the rule…Spend less than you earn. What compound interest does is help you build your balance sheet. It goes onto your budget as income and comes off on the spending side as money addressed to savings.




Is there a Compound Interest Formula?

There are 2 relevant formulas. One is the Compound Interest Equation and the other is the Rule of 72. The first one is pure math and there are several versions of it. The rule of 72 is the simplest and is crystal clear with the most simple math ever.

Here is one example of several different versions of how to calculate compound interest.

A = P(1.0 + r)n

A is the total amount of the investment
P is the original amount of the savings asset
r is the rate of interest...for example 5% is .05 and that is added to 1.0
n is the interest is paid out which is usually annually. It is exponential...that means that you multiply what is in the bracket times itself by the number of times.

I put this in just to show that there is a formula that mathematicians use for the calculator included on this page. Far easier and far simpler is the Rule of 72. This rule states that you take 72 and divide it by the interest rate you are compounding your money with and you will arrive at the number of years it will take to double your money.


Question: Why should you save and use compound interest?


Answer #1:


In your life plan the first place where compound interest is relevant is for funding your retirement. Even if you have an employer sponsored pension plan, it will use the concept of compound interest. More and more, folks are being left to figure out how to fund their retirement on their own. The most important tool in building retirement savings and therefore retirement income is compound interest.


Let’s look at an example: These numbers are approximations. The point is to draw a picture of what saving and using compound interest will do for you in your retirement. Do not get hung up on details in the numbers as not matter what these the specific numbers will change over time but the big picture is constant. Let’s take a lump sum of $5000 compounded at 5% and see how it works in a tax protected retirement savings plan. Assuming that you are in a 30% tax bracket, you will receive a tax rebate of $1500. That makes your original input only $3500 out of your normal take home pay. In 25 years the balance in your retirement account will be $16,931.77. That is almost 5 times the original out of pocket expense of $3500. That is miraculous.


We add to the miracle by taking that $5000 of which you receive $3500 back and then for 25 years deposit $200 per month into your retirement fund. Out of that $200 you get $60 back at the end of the year. Your balance in 25 years at 5% will be 137,204.06. However it will only have cost you $3500 + $41,860 (299 X $140) = $45,360.


Once you retire you can take that interest and then pay it to yourself to replace the income from your paycheck. This amount of savings at 5% could pay you $571.68 per month just in interest. If you treated it as an annuity and paid yourself some of the principal plus the interest each month for 20 years you would pay yourself back $571.68 per month in principal plus 284.85 a month in interest. Total would be $857.52 per month for the first 20 years of your retirement. Put your own numbers into the calculator and make your own personal plan...look at your options.


Answer #2:

The interaction of your owning your home and paying down your mortgage is the most powerful investment available to the regular Joe or Jane. Over a lifetime, the purchase of your home should act as a savings account that appreciates in value on a compounded schedule. In the short term it may go up or down in value but if the location choice is a wise one, the value of the property should increase over 25 to 35 years on a compounded schedule similar to the 5% example in answer 1.


Paying down your mortgage is a debt version of compound interest. As you pay down your mortgage, you pay less and less interest on your mortgage and pay off more and more of the principal on a schedule that is a version of saving and compounding interest.

Conclusion

It is not out of ignorance that people do not use this tool because everyone is schooled at some point about THE MIRACLE OF COMPOUND INTEREST. I am as guilty as anyone. However, I was lucky enough to have mentors who took some of my income and used this tool to build a large part of my financial security. If you are not so lucky let us look at why you need to have this awesome tool working for you ASAP.


All you have to do to have this tool work for you is to save regularly. You need to save some money each and every month and then you need to invest it in Certificates of Deposit/Guaranteed Investment Certificate for long terms. That way you get the best rates. As you deposit the rates may go up and down but over 25 years they will average out.


Pure simplicity


Listen to budget angel and spend less than you earn…Save. Listen to balance sheet angel and own more than you owe…put your money into an asset that earns compound interest and add to it over your lifetime. Listen to life plan angel and plan your retirement income and plan to own your own home.



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