Ever heard of the idea that the rich get richer while the poor get poorer? It’s a popular concept, especially in today’s economic environment and a lot of it has to do with compounding interest.
Simply put, compounding interest can be one of the biggest levers of financial success when put to work for you, and one of the biggest contributing factors to financial collapse when working against you. It’s like rolling a snowball down a hill. It may start off as only a tiny snowball, but as it rolls downward it gains momentum and accumulates snow. When it finally settles at the bottom of the hill it’s a snowball big enough to marvel at.
The longer the hill, the longer it has to accumulate snow, and the larger it’ll be by the time it reaches bottom.
The same concept can be applied to investing. The earlier you invest, the longer your “hill” is, and longer you’ll have for your “snowball” to gain size.
The cost of waiting
It’s human nature to procrastinate. The concept of delayed gratification is constantly shoved aside by the commercially driven, need it yesterday, materialistic society that we live in. On top of that, we’re talking about tucking cash away in an account that we can’t touch for 20 – 30 years. Talk about ultra-delayed gratification!
It’s critical to understand that the cost of waiting to invest is huge enormous. Waiting even a couple years to start investing will have a significant impact on the amount you’ll have later down the road.
[Related tip – Prepare Yourself Before You Invest]
Let’s look at an example. If you start investing $5,000 per year at age 20, and earn an 8% annual return you’ll have just over $2 million by the time you retire at age 65. Wait just 5 years later to start and that amount goes down to $1.4 million – a difference of almost $700,000. Ouch!
To see how much of a difference compounding interest accounts for your future, check out the compounding interest calculator by moneychimp.
Compound interest can work against you
In the same way that compounding interest can be leveraged to your advantage by investing wisely, it’s also important to understand that it can be leveraged against you when holding debt.
Credit card debt is the biggest offender of this.
Keeping with the snowball analogy – let’s now imagine that you’re on someone else’s hill, and with some else’s snowball. Lets call this hill “Chase Bank”. The same forces of nature apply to Chase’s hill that apply to your hill. Once the ball starts rolling it gains momentum, and the second you start sprinting down the hill to stop it you discover there’s too much momentum behind it and you get plowed over.
That’s exactly the downward spiral too many people face when it comes to credit cards. Debt continues to compound until it becomes simply too much to handle, and it plows right over us.
The next time you go shopping, take a minute to think about what the true cost of the item you’re buying is. After factoring your credit card APR into the equation, it won’t take long to see that you’re paying much more than what’s listed on the price tag.
If you feel like giving yourself a healthy dose of credit card reality, run a few calculations through this cost of credit calculator.
Focus on getting out of debt
Now we see why it’s so important to focus on getting out of debt immediately and begin funding your investment account.
To become financially successful you’ve got to put the forces of compounding interest to work in your favor. It all starts with getting out of debt.
Make regular investments & be patient
Becoming financially successful also means regularly contributing to your investments and simply being patient. Compounding interest is a waiting game…literally. It’s worth it in the end though.
So it turns out your grandparents were right all along. Every time they gave you that crisp $5 bill for your birthday and told you to stick it in your savings account it was because they’ve seen the power of compounding interest firsthand. Be sure to put it to work for you today!