The Magic and Myths of Compound Interest

Understanding the power of compound interest is perhaps the most important concept that anyone can use to save and accumulate wealth. The phrase “you need money to make money” was never truer when it comes to compound interest. Compound interest can make a small pile of money turn in to a big pile of money. The 2 key elements that make compounding work are interest rates and time. Following is an explanation of some of the magic and myths of compound interest.

What Exactly is Compound Interest?

Compound Interest is the process by which interest is calculated. It can be compounded in different increments. The greater the number of times it is calculated, the higher the rate of return. In most instances, compound interest is calculated daily, although it can also be compounded weekly, monthly or any other increment of time. Your money earns interest on the original balance plus the amount of interest that has been earned up until the date of calculation. The basic formula is principle invested + interest earned to date x interest rate = compound interest. Over the course of time, interest accumulates. That interest is added to your original principal, creating a constantly updated principal amount. Multiplying your increasing new principle amount by the same original rate of interest yields a bigger return over the course of the period of time you have your money invested.

The Rule of 72

This is not an exact formula, but it is a good estimate of how long it will take your money to double in value. Simply divide the interest rate in to 72 to get the term or time in years it will take to double. As an example, if you invest $10,000 at an average rate of return of 12%, you will have approximately $20,000 after 6 years. The formula is 72/interest rate =Time to Double. In the above example, 72/12 = 6.

The Magic

Without having to touch your money or make any decisions other than the original decision to invest some money, your investment will multiply itself. You do not need to buy or sell or concern yourself with any outside events that often determine the growth potential of other investments. Your money, if left undisturbed will grow with certainty based on the interest rate or annual rate of return and the length of time that it is allowed to grow.

Myth Number 1 – Compound Interest Guarantees Future Wealth

It all sounds so easy. Just put your money in, leave it alone and in a few years, you’ll have more than what you started with. Well, that may be true, but it does not guarantee that you will be wealthier than when you started. You must remember that while your money is earning a return based on a certain interest rate, the effect of taxes and inflation can eat up any nominal dollar gains. If you have a 5% compounded interest rate on your investment and inflation is also 5%, in the end, you just break even. Actually, if you have to pay taxes on the passive income you earned, you will effectively lose money and purchasing power.

Myth Number 2 – Compound Interest is a Good Investment

Compound interest is not an investment, but rather, a predictable rate of return. You invest in real estate, stocks, bonds and other financial instruments. You earn a return which can be expressed in terms of an interest rate. You earn compound interest when you take your money and allow it to grow at a specified interest rate.

Myth Number 3 – Compound Interest Only Makes Your Money Grow

Just as compound interest can build your portfolio up, it can also be a burden when you owe money. If you take out a loan and the interest rate is compounded daily, you will pay higher monthly payments than if it was a simple interest loan. If you are late or miss a payment or two, the power of compound interest can result in your owing even more than you might have imagined.

Myth Number 4 – Projections are not Reality

It is very easy to use compound interest to make forward projections and show how rosy things are. However not many investments have guaranteed returns (and even then read the fine print and realize that a guarantee is only as good as who ever is making the guarantee – it may not be who you think). So if it looks too good to be true, it may well be so. Look deeper at how it is possible. Generally the higher the return the higher the associated risk. Watch out for that risk.

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