Worldwide Success

When it comes to money and being financially successful, one of the most important concepts you need to understand is compounding.  From a financial standpoint, compounding is the cumulative effect of investment returns or interest.  In other words, it is the earnings on top of the earnings, the interest on top of the interest.  But the word compounding can also be defined as “to produce by combining two or more ingredients.” The two ingredients that fuel the power of financial compounding are the return or interest rate and time.

Compounding can work for you or against you.  Let’s take a look at one example of each:

Compounding Working for You

When you are young, the last thing you want to do is think about saving money for retirement.  Most people rationalize that they can worry about that when they are older.  But what they don’t realize is how time can have a huge impact in your savings.  Let’s look at an example:

1. John didn’t think about saving for retirement until the age of 35.  But from that point on he started contributing diligently to his retirement plan until he retired, contributing $1,000 a year for a total of $30,000 over a period of 30 years.  John’s money was invested, and because of the power of compounding, his contributions grew to $122,246 by the time he retired at 65!

2. Mary was an early saver.  She figured she needed to save as much money as possible early on because she understood how time can be a powerful variable when it comes to compounding.  She started saving at the age of 21, contributing the same amount as John and investing in the same investment vehicles, at the same rate of return.  However, due to unforeseeable circumstances, Mary was unable to continue contributing.   She was only able to contribute a total of $10,000 to her retirement plan over a period of 10 years, and then she stopped contributing completely.  She left the money invested until retirement, and as a result at the age of 65 she had accumulated $214,189!

Even though Mary only contributed one third of what John did, she ended up with 75% more money than John, simply because she started contributing 14 years earlier!

Given a fixed rate of return, the time ingredient can have a dramatic impact on the amount of money you can accumulate!

Compounding Working against You

How much credit card debt do you carry?  Are you paying more than just the minimum amount each month?  Let’s take a look at what happens when you only pay the minimum amount each month.  This analysis assumes that the minimum payment represents 3% of your outstanding balance on a credit card with 18% nominal annual interest rate:

Debt of $1,000

You will pay a total of $1,684 for your debt including $684 in interest charges over a period of 8 years!

But if you pay 6% of the outstanding balance instead you will save $399 in interest and pay off the loan in 4 years.

Debt of $5,000

You will pay a total of $9,567 for your debt including $4,567 in interest charges over a period of 16 years!

But if you pay 6% of the outstanding balance instead you will save $2,975 in interest and pay off the loan in 7 years.

Debt of $10,000

You will pay a total of $19,421 for your debt including $9,421 in interest charges over a period of 20 years!

But if you pay 6% of the outstanding balance instead you will save $6,195 in interest and pay off the loan in 8 years.

As you can see, paying only the minimum on your monthly balance will almost double the amount of money you will have to pay to cover for interest charges, and it will take many years or even decades to pay off a debt of just a few thousand dollars!

Paying even a small amount above the minimum payment each month will have a dramatic impact in the total amount you will pay and how long it will take to have your loan paid off!  When we talk about debt, compounding works against you.  The sooner you pay off your debt, the less fuel compounding will have to negatively impact your financial success.

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