Interested in getting rich? Do this and watch your wealth multiply
Albert Einstein famously described it as the eighth wonder of the world. Billionaire investor Warren Buffett swears by it. Here’s what you should know about compound interest.
Compound interest sounds like a cross between a chemistry experiment and something your bank used to pay into your savings account.
But it’s actually the most powerful financial tool on the planet.
And it can make you rich through a simple three-step process.
Step one: Invest money into growing, income-producing assets.
Step two: Reinvest all the income from the asset into buying more assets, and try to inject extra money of your own every month or year.
And step three: Wait 10 or more years, ideally a few decades, and voila! You’re rich.
While it’s not quite that easy, and all investments are subject to the crazy moods of financial markets, it’s not too complex either.
Compound interest is simply the process of earning interest on your interest on your interest, and so on.
Perhaps we should swap the word “interest” — which is almost non-existent in today’s financial world — with “income”, which is still in abundance among shares, corporate bonds, property and infrastructure investments.
The two key ingredients for success with compound interest are patience and a plan. If you don’t believe me check out the free compound interest calculator at ASIC’s Moneysmart.gov.au and plug in your own numbers.
Let’s say you have $10,000 invested in shares and earn an annual return of 8 per cent on it.
According to the Moneysmart calculator, after one year you have $10,800, but leave it to reinvest and grow for five years and it balloons to almost $15,000.
After 10 years that $10,000 investment compounds to more than $22,000 — even if you‘ve added nothing else since your initial outlay.
After 20 years it’s almost $50,000 and after 30 years it’s more than $100,000.
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The biggest gains from compounding come in the later years, which is why it is such a powerful investment strategy for superannuation. Because our money is locked away until retirement, there is no temptation to dive in and spend it.
In fact, just $1000 invested at age 18 and allowed to compound until age 68 will turn into more than $50,000, based on an investment return averaging 8 per cent a year.
A lower investment return will reduce those gains, but a higher return multiplies them.
Compound interest also has dark side that Darth Vader would be proud of. When it’s applied to debt, particularly high-interest debt such as credit cards, its effects can be devastating.
If you have credit card debts of $10,000 and don’t pay them off, compound interest at the average credit card interest rate of 20 per cent will more than double the size of that debt to $22,000 in just four years.
This is why there’s no point putting money into investments while you’re saddled with high-interest debt.
For investors, compound interest will work best with a diversified portfolio of assets. This will prevent the potential problem of investing in one or two big companies that go gangbusters for years but then collapse to zero.
If you have patience and stick to a plan, you’ll find compound interest is more powerful than any chemistry experiment.