THE MAGIC OF COMPOUNDING INTEREST AND MAKING IT WORK FOR YOU
Editor’s Note: This is the second of two blogs highlighting wealth-building principles from the book, The Psychology of Money. (We highly recommend it.) Our first blog discussed the difference between being rich and being wealthy.
Time is money.
Coined by a Founding Father, Benjamin Franklin, this oft-repeated phrase tells us that we should use our time wisely and productively. Wasting time could lead to financial loss, and we may miss out on valuable money-making opportunities.
Sounds ominous, doesn’t it?
Not in the case of compounding or “compounding interest” as we frequently hear the word.
Time is compounding’s best friend, a magical force for financial reward.
Morgan Housel writes in his book, The Psychology of Money, about “confounding compounding.” It’s “confounding” (or confusing) because the concept is hard for us to grasp. It’s simply too good to be true.
Defined, the process of compounding is adding earned interest back into the principal, or original sum of invested money. I imagine compounding as literally putting dollar bills received in interest back into the “pot” of principal to start earning interest on itself in the next period. This means your money grows at an accelerating rate as the earnings from each period are reinvested and generate additional returns
Example: You invest $100 with a 5% interest rate and earn $5 in interest after the first year, bringing your total to $105. The next year, you’ll earn interest on $105, not just $100, and so on.
Many investors liken compounding to a snowball rolling downhill, growing bigger and bigger as it accumulates more snow along the way. “The important thing is finding wet snow and a really long hill,” said Warren Buffett.
The two secrets to compounding success are time and money.
“None of the 2,000 books picking apart Buffett’s success are titled, ‘This Guy Has Been Investing Consistently for Three-Quarters of a Century,’ writes author Morgan Housel. “But we know that’s the key to the majority of his success.”
(Check out Alia’s complimentary financial literacy “course” for more of Warren Buffett’s investing wisdom.)
The sooner you get started, the more time your investment has to grow, thanks to compounding interest. Additionally, maintaining consistency in investing enhances the power of compounding.
TIP: Automate regular contributions from your bank account to your investments each month. Over time, you won’t flinch when you see the automatic withdrawals from your bank account, but you will do a happy dance when you see the compounding effect create significant returns.
While there’s talk of the Great Wealth Transfer, boomers are increasingly holding on to their money to compensate for increased daily living costs and to plan for healthcare and other long-term care needs.
“ … Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can’t be repeated,” Mousel writes in The Psychology of Money. “It’s about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That’s when compounding runs wild.”
We’d be remiss if we didn’t touch on compounding interest with debt. Just as compounding works its magic on building wealth, it does the same, working against you, with debt.
This means that if you don't pay your balance in full each month, especially high-interest credit cards, any unpaid interest gets added to your principal. Then the next month’s interest is calculated on this larger amount, creating a cycle where your debt grows faster and faster, and it becomes harder to pay off.
TIPS TO AVOID COMPOUNDING INTEREST WITH DEBT:
Pay more than the minimum to reduce the principal and amount of interest you'll pay over time.
Prioritize high-interest debt and pay those off first.
Be mindful of compounding frequency, or how often interest is compounded (e.g., daily, monthly) as it can affect how quickly your debt grows.
Let’s talk more about the magic of compounding interest and how it can make your Possibilities. Made Possible. Contact us today.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
