COMPOUNDING - HE WHO UNDERSTANDS IT, EARNS IT. HE WHO DOESN'T, PAYS IT


COMPOUNDING - HE WHO UNDERSTANDS IT, EARNS IT. HE WHO DOESN'T, PAYS IT

Published on April 02, 2015

The wonders of compounding interest

The concept of compounding has been around for a very long time but there are few who truly understand its power or take advantage of it to build wealth.

Did you realise that if you double one cent 30 times you get $5,368,709.12? Double it just once more and you get $10,737,418.24; that’s almost 11 million dollars!

Interestingly, after five days of doubling the one cent only grew to 32 cents and after 10 days to just $10.24. This demonstrates that although the power of compounding may not not initially be evident, it is there in spades at the back end.

Think about that for a moment; procrastinating - even for just one day - comes with a massive opportunity cost attached to it. Compounding means we will pay dearly for procrastinating; perhaps not up front but absolutely at the back end.

Given the odds of a sound financial future finding you are somewhere between zero and none, why wouldn't you take action now and give yourself a fighting chance to become independently wealthy and retire early with no need for the pension?

So what is compounding and how does it work?

Compounding

While many people may already know that compounding is the process of generating earnings on an asset's reinvested earnings, very few put changes in place to take full advantage of it.

Compounding is possible once your initial asset has grown in value enough to offer the additional equity necessary to purchase subsequent assets.

Once your initial asset has seen sufficient growth in value, you can draw the necessary capital from there to secure another asset.

So now you have two assets, which in turn continue to grow in value and provide capital for two more. Then you have four. Those four assets grow in value and provide capital for four more… you can see the pattern.

Much like my doubling of one cent example, compounding takes time and effort at first, but really kicks in to grow your wealth significantly in time.

Compound Interest

Compound interest is essentially earning interest on interest.

When discussing compound interest, Einstein summed it up perfectly saying, “He who understands it, earns it... he who doesn't... pays it”.

This means it’s important to understand compound interest from both ends of the spectrum to get the most out of it.

On one hand, people look to use it to their advantage to grow wealth – using the multiplying effect to grow assets exponentially.

Therefore, they would be making deposits, earning interest on the deposit, and then earning interest on their deposit plus the initial interest, and so on as it gradually accrues over time.

On the other hand, any interest accumulating on your credit card debts or personal loans - what I like to refer to ashorrible (i.e. bad debts) - would be compounding in a way that pushes you further behind in the long term.

To lessen the effects of compound interest while it’s working against you, make repayments towards your bad debt more frequently than that rate it is compounded, this would reduce the balance that gets compounded, ensuring you pay less interest over time.

As you can see, understanding how compound interest works is incredibly valuable for everyone, regardless of their situation.

Why investors often miss out

Despite the value of compounding being so widely known, many investors aren't taking advantage of it because they’re being too conservative.

Leaving it too late to start contributing to an investment portfolio makes it more difficult to catch up later in life and leaves investors more at the whim of financial market fluctuations during the catch up phase.

At the end of the day, the more time you give your investments (i.e. time in the market), the more you are able to accelerate the income potential of your original investment – the marvels of compounding.

How to make sure compounding is part of your investment strategy

If you currently have an investment property we can assist you to structure your finances in such a way as to pay down non deductible debt, such as the mortgage on your own home, faster. Ask us!

MRD have the knowledge, the research and the services to help people kick start their investment portfolio and, through strategies such as compounding, eventually attain financial freedom. And it’s the application of many little ‘one percenters’ along the way that will enable you to achieve your goals faster.

We not only teach you smart investment strategies, we’ll mentor, support and partner with you all the way.

Contact us online and tell us exactly how you’d like us to help you at this time. Alternatively, phone us on 1300 883 854 or send an email to office@mrdpartners.com.au. Remember to leave your name and best contact phone number so we can come back to you with more information and offer you a complimentary consultation to establish your long-term investment needs.

Partnering with you for your investment success,

Nick Lockhart.