Monday 19 September 2016

Compound Interest. Step by step, how compound interest works.

https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh2wvlgUKW7G51ACMJoNPlMOQQb76iQFEWz7CZJr2DHtLfD56Gw6gTktW4fRjDQOzagyiiIjJSbxdc4WB_ZzV0zhPptADAPxj7IHY9OvBr7GEQO7vbtW8frfCoxTer41POhac_EWSqa4q4/s640/Compound+interest+-+Constancy+Wealth+Management.jpg
 
Pop quiz, who said
 
"Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it. Compound interest is the most powerful force in the universe. Compound interest is the greatest mathematical discovery of all time."
 
The answer, Albert Einstein of course. Almost everyone has heard of Compound interest but few really understand how big of an impact it has on our everyday lives. Every loan we apply for, every mortgage, credit card, savings account, superannuation policy and investment including the family home is subject to compound interest. By understanding Compound Interest we can use it to reach our Financial goals.
 
What is compound interest?
The basic principal of compound interest is earning additional interest on interest. Once you earn your first interest payment, it is added to the principal. Let me explain in an example.
 
If you invested $100 and in the first year your investment return was 10% you would have earned $10 bringing your total investment to $110
 
$100 x 10% = $10
$100 + $10 = $110

If in the second year your investment return was again 10% you would have earned $11 bringing your total investment to $121
 
$110 x 10% = $11
$110 + $11 = $121
 
If in your third year your investment return was again 10% you would have earned $12.10 bringing your total investment to $133.10. 
 
$121 x 10% = $12.10
$121 + $12.10 = $133.10
 
So by receiving three years of compounding 10% returns your balance is not 30% higher but 33.1% higher.
 
https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQgULnFp5yV_dzTR73RbxrSKg39osLg9Xip5eCRiihtOTXoG6qJ8hQgkLP6ZzRGbhz-FIEkKTHGBhEHlirTyCKfUue55mWK2cm8uRPQBH-DJLvYLSC82LGKNVa0IXKmHwfUW31UPmcYo4/s1600/formula-compound-interest.pngThere is a formula for calculating compound interest which you can easily use in Microsoft Excel. Alternatively there are many compounding interest calculators available online including the Money Smart website
 
 
"He who understands it, earns it."
Compound interest is the reason why Financial experts say to start early. By saving that little bit of money each week to put into the mortgage, pay off debt, contribute to super, save for that home deposit or that big holiday will make a big difference towards achieving your financial goals. In fact the earlier you start the bigger impact your small savings will make. Superannuation will likely be the longest investment you ever have and will therefore gain the most benefit from compounding interest.
 
It is human nature to spend what you earn and the idea of finding money you do not need can be daunting to most. The key is to make small gradual steps in the right direction. Every pay cycle set up an automatic transfer of what you think you can afford. Maybe its only $5 or $10 a week but it is $5 or $10 a week you weren't saving before. Try that for a couple of weeks and see if you even notice the money gone. Then try increasing your savings to $15 or $20 per week and see what sort of impact it makes you on your lifestyle. Many people struggle to accrue savings but by taking these small gradual steps you will end up building yourself a financial safety net that will reduce financial stress, build good financial habits and allow you to achieve more financially than you thought possible.
 
"He who doesn't, pays it."
Hands down compound interest is how banks make their money. Yes there is money in fees but not as much money as compound interest on debt.
 
Did you know most credit cards only require a minimum repayment of 2% or about $25 per month. So if you had a $6,000 credit card maxed out with a 20% interest rate, never made another purchase and only paid the minimum repayment of $120 per month you would pay an estimated $7,000 in interest. That is just insane.
If you decided to double your repayments to $240 per month, which is only $55.40 per week, you would only pay an estimated $1,827 in interest. What a difference! That is the power of compounding interest and starting early.
 
Conclusion
If you were to take away one thing let it be this, even the smallest contributions over time can make a big difference. Put aside a little bit of money every pay cycle to help pay off debt or build your savings. Saving is just as addictive as spending if you have a goal, even if that goal is to form good financial habits.
 
Please check out our website www.constancywealthmanagement.com.au
 
 
What you need to know
 
Constancy Wealth Management is an Authorised Representative and Credit Representative of AMP Financial Planning Pty Limited ABN 89 051 208 327 AFSL 232706 and Australian Credit Licence 232706. This information does not take your circumstances into account, so read the relevant disclosure documents and consider what’s right for you. If you acquire an AMP product or service, AMP companies and/or their representatives will receive fees and other benefits, which will be a dollar amount and/or a percentage of either the premium you pay or the value of your investments. Ask us for more details.
 
This post contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information
 
 

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