Thursday, November 08, 2007

Miracle of compound interest - getting rich slowly but surely


Miracle of compound interest - getting rich slowly

I found a great article on the miracle of compound interest over a Kiplingers.com Here is what the article said with my comments.

The article says that compound interest maybe one of the eighth wonders of the world. What compound interest does is it turns a little bit of money into a lof of money over time, if it is invested wisely. Good old Albert Einstein said to have called it one of the greatest mathematical concepts of our time.

Compound interest formula: Since we are talking about Albert lets get into the math of compound interest. This formula is very simple, however most people don't understand it. So here it goes.

FV = PV(1 + i)n

The above calculates the future value, (FV), of an investment or present value, (PV), accruing at a fixed interest rate of i (this is the yearly rate) for n periods (usually this is number of months)

So when you save or invest, your money earns interest, or appreciates. The next year, you earn interest on your original money and the interest from the first year. In the third year, you earn interest on your original money and the interest from the first two years. And so on. It's like a snowball -- roll it down a snowy hill and it'll build on itself to get bigger and bigger. Before you know it ... avalanche!

Tips on harnessing the power of compound interest

1. Start young. When you're in your twenties and thirties, your best friend is TIME. Start rolling your snowball at the top of the hill and you'll have a much bigger mass at the bottom than someone who started halfway down. I heard a news story the other day that said if you are 21 and you just started saving $50 per month when you get to age 65 you would be a millionare. Pretty amazing.

Here's another example sited by the article: Amy, a 22-year-old college graduate, saves $300 per month into an account earning 10% per year for six years. (That's the average annual return of the stock market over time.) Then at age 28, she starts a family and decides to stay home with the children full time. By then, Amy had kicked in $21,600 of her own money. But even if she doesn't contribute another cent ever, her money would grow to a million bucks by the time she turned 65.

Compare that to Jason, who put off saving until he was 31. He's still young enough that becoming a millionaire is within reach, but it will be tougher. Jason would have to contribute the same $300 a month for the next 34 years to earn $1 million by age 65. Although Amy invested less money out-of-pocket -- $21,600 over six years vs. Jason's $126,000 over 34 years -- her money had more time to grow, or compound. (Find out what it'll take for you to make $1 million.)

Bottom line: Getting rich is easier and more painless the earlier you start. Check out our 30-Minute Investing Start-Up Kit to get started right now.


2. Remember that a little goes a long way. Don't think you have enough money to start investing? You can get into a good mutual fund for as little as $50 a month. Consider another case of Jason who was starting out and got his first job and started saving in the companies savings plan. He invested money every pay check for 3.5 years. He ended up contributing $6200 over 3.5 years and then left the company. He left the investment in the company plan and once a year adjusted the mutual funds that he was invested in and after 20 years the account grew to $30k. Five times his orginal investment.

A little bit can make a difference elsewhere in compounding, too. For example, if our 20-year-old earned 9% annually instead of 10%, he would amass only $373,000 in the same period of time. That seemingly small 1% difference in performance resulted in 29% less money over the long haul.

Another thing that I recommend is that you buy yourself a good financial or business calculator and you learn how to use it. Most people have know idea how to calculate a car payment or house payment or how much their credit card debt is costing them. The business calculators use to be expensive but now days you can get a nice one for under $30.


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