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
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.
There 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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