How to leverage the power of compound interest to work in your favour to build wealth.
This post contains affiliate links; please read our Disclosure for more information.You have ambitions to build wealth, right?!
I’d be hard-pressed to find anyone who would deny this. But many focus too much on the latter word than the former.
Building anything requires a plan, a team and time.
Compound interest cuts across all three of these elements.
Part of your wealth-building team should be our good friend compound interest.
And compound interest needs time to really grow.
Today, I’d like to make the case why you should poach compound interest.
I say poach because it’s always at work for financial institutes. Time to make it work for you too.
Compound Anything
I’m a musician.
I play a few instruments but I mainly play the bass guitar and I love it.
Many people would love to learn to play an intrsument. I know plenty who started then gave up soon afterwards.
It takes patience and time. Practising the same thing. Over and over. Until it gets boring.
This is how compounding works, with time and patience.
Doing the boring thing over and over again until it comes ‘naturally’ to you.
The Compound Effect explains how small actions, executed consistently, lead to successful results.
It’s time to add interest to your list of compounded elements in your life.
Compounding Interest Explained
To understand compound interest, let’s first look at simple interest.
Say you save £3,000 to be locked away for 3 years for 10% interest per year.
The maths is, 10% of £3,000 = £300 per year. After 3 years it’s £900.
This means you’ll receive £900 in interest after the 3 years.
Making the total amount you’ll get back £3,900.
That’s the simple version of interest.
The power of compound interest is more magical than this.
What Does Compound Interest Mean?
According to Investopedia, compound interest is the interest calculated on both the initial money borrowed and the accumulated interest from previous periods.
In simpler terms, it’s the interest added on top of interest. Or as some would say, interest on steroids.
Let’s break it down using the example above.
The 10% interest rate is added on a yearly basis.
10% of £3,000 is £300 in year one. Total after year one is £3,300.
In year two, 10% is added on £3,300 which is £330. Making the total £3,630 (£3,300 + £330).
Finally, in year three 10% is added on £3,630 which is £363, making the total £3993 (£3,630 + £363).
Adding up just the interest makes the compound interest £993.
In comparison simple interest is £3,900 total and compounding interest is £3,993.
That extra £93 is the compounded interest that was added on top of the ‘simple’ interest.
Hence compounding interest is interest-on-interest.
How Do You Calculate Compound Interest
The formula for compounding interest is:
To be honest the majority of us won’t ever need to remember this formula.
You can simply use an online compound interest calculator that does the hard work for you.
The aim is that you are aware that there is a method to the magic and power of compounding interest.
Unless if like me you’re the curious type to want to know how things work.
How Does Compound Interest Work Against You
Recall earlier I said it’s time to poach compounding interest to work for you.
Well, this is why.
The power of compound interest doesn’t discriminate, it simply exists.
One major area it works hard for banks but against you is with debts.
Specifically, credit card debts.
Let’s say you owe £2,000 on a credit card with 24% APR (Annual Percentage Rate).
This means you’ll be charged 2% every month for amounts owed.
After month 1 you’ll be charged 2% of £2,000 which is £40.
If you don’t pay anything back, in month 2 you’ll be charged 2% of £2,040 making your amount due £2,020.40.
May seem small but over long periods of time this will grow significantly if left unpaid.
The banks catch you by saying you can just make the minimum payment.
Only paying the minimum means more money for them as compound interest will be growing silently.
If you only made minimum payments (~£50 per month) to the card above you’ll repay a total of ~£5,400 over 24 years!
That extra £3,400 is all compounded interest from your spent £2,000, grown over 24 years.
Some credit cards calculate interest daily instead of monthly.
This is how compound interest works against you!
Time to rewrite the script and make you the star of the show.
Pay off your debts and make compound interest work for you.
How Does Compound Interest Work For You
Let’s poach.
Start saving and investing.
These days saving accounts have super low interest.
This low interest simply means the growth potential is slow.
There’s not much compounding that will happen on an account paying 0.1% per year.
If you put £10,000 into a savings account for 5 years with 0.1% interest you’d gain £50 at the end of it.
Pointless!
But there’s an alternative.
Start investing in the stock market.
On average the stock market yields an 8% annual rate of return. Now we’re talking!
That same £10,000 over 5 years with 8% compounded earns you ~£4,700.
This is what people refer to when they say make your money work for you.
Take your money and put it where it will partner with compounding interest to make you more money.
Investing is the best way to make the power of compound interest work for you.
It will accelerate your journey towards financial independence.
Your Biggest Enemies of Compound Interest
There are two main destroyers of compound interest – impatience and inflation.
Today’s world is built on instant gratification.
The little number at the end of the compound interest formula is probably the most important one.
Time.
Compound interest is like learning an instrument.
Painful and seemingly pointless in the beginning. But if you stick with it you’ll eventually get the rewards.
If you let your investments stay in the market, they’ll grow over time.
The problem is, we can be impatient. We’d rather seek immediate thrills.
It’s okay to be boring, remember that’s how you compound and get better.
Play the long game. See the growth curve!
The second enemy of compounding interest is inflation.
Inflation is simply the increase in the cost of goods and services which in effect devalues your money.
Inflation is 2% on average.
This simply means something that costs £1 today will cost £1.02 (£1 + 2%) tomorrow.
The danger is, savings rates are less than 2%. Hence inflation being an enemy.
The vehicle of savings just doesn’t have enough horsepower to overtake inflation.
But investing does!
Don’t let these two enemies of compound interest detract you from making compound interest work for you.
Leverage The Power of Compounding Interest To Build Wealth
Compounding interest is the 8th wonder of the world. Those who understand it earn it, those who don’t pay it.
Either Einstein or Lincoln said this.
I can neither confirm nor deny, I have no idea who said it.
But it hits the nail on the head.
Understand it and you’ll make compound interest work for you.
Don’t and you may end up having compound interest work against you.
Leverage the power of compound interest and build wealth by doing two things.
Repay all credit card debts with urgency and invest in the stock market over a long period of time.
The total opposite to what most will do today.
Most people carry credit card debts for a long time but hunt for quick wins on their investments.
Repay your credit card debts in rapid speed to prevent compound interest working against you.
Invest in the stock market over long periods of time and let compound interest go to work for you.
Not always easy to do, but simple.
The power of compound interest will work for you, if you poach it and stick with it over time.
Take Action
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Knowledge is powerless without action
So take action, and take care
Thando
