Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t, pays it”. I agree with his statement but also believe most people don’t really understand the magic of compounding. About six months after starting my first post college graduation job, I started saving money from each paycheck with my bank. Back then there weren’t many investment options available so I started with a bank savings account. At the time I conceptually understood the concept of compound interest but it was hard to ‘internalize’ the concept until I saw it actually happen in my savings account. I invested $1,000 and earned 3% (yes, interest rates were higher back then) so one year later my account had $1,030. The next year, instead of earning another $30, I earned $30 on the $1,000 plus I earned $0.90 on the $30 of interest from the year before. It didn’t seem like all that much at the time but as I also added money to the pot it began to grow surprisingly fast. In fact, I used this savings plus borrowed some money from the bank to purchase my first piece of real estate…a 4-plex apartment building and this simple act of saving ‘consistently’ helped launch my journey of wealth accumulation, of course later in life I just needed the property bellow and the building wasn’t so valuable, so I got Atlanta Demolition Services to knock it out.
The magic of compounding is simply earning money on your money and also earning money on the earnings on your money…over and over again. Unfortunately, in 2008, our government began interfering in a significant way with interest rates. While well intentioned, the effect has been to drive interest rates down to historical lows. For example, historical rates for a 10-year treasury bond prior to 2008 was 4-5% while today the 10-year treasury is yielding a paltry 1.6%.
Compounding’s Rich Uncle
For most people, earnings at current interest rates, even with compounding, will not be enough to fund a retirement lifestyle anywhere near your current lifestyle. An alternative approach is to blend compounding with the potential growth of the stock market. This can be achieved with a basket of blue chip dividend-paying stocks. As one example, look at Proctor & Gamble. The current dividend yield is just over 3% annually. More importantly, they have paid a dividend every year for over one-hundred years without missing. They have also increased their dividend every year for the past 59 years. Dividends also receive favorable tax treatment and are taxed at much lower rates than interest payments. This is why I call companies like P&G ‘Compounding’s Rich Uncle’. If you reinvest the dividend, you’re getting the benefit of compounding and since they are raising their dividend payout every year, eventually their stock price also has to rise.
Compounding’s Evil Twin
Compound interest is a two-sided coin. On the one side are all the positive effects we discussed above. The other side is what happens to you when you borrow money. Let’s assume there’s a special offer to purchase an appliance for your home for $1,000 with no payments for three years and an interest rate of 21%. Compound interest is now working against you in a big way. In fact, when your payment comes due in five years, you’ll owe over $1,800! In our financial advisory practice, we see some version of this play out just about every week in the form of auto loans, credit card debt, store credit debt, and even home equity lines of credit and mortgages.
As managers of our family’s finances, it’s incumbent of each of us to understand how compounding works and manage it in a way that benefits us rather than enslaves us.