Albert Einstein once said that the single most important invention ever conceived by man was the miracle of compound interest (or something to that effect). And I agree. I find a lot of people that don’t understand the concept of compound interest, and as a result they do not value the small change that they should be saving instead of wasting it on impulses and cravings.
What is a dollar here, or two dollars there on snacks? Its nothing right? Wrong! It may seem like nothing now, but it could cost you tens of thousands of dollars in the future. Far fetched? Read on.
Let me start by explaining the concept of compound interest. Its actually pretty simple. The whole idea is that you earn interest not only on your money but on the interest that you are earning. So if you have 100 dollars in a government bond that is giving you 10 percent per anum, after the first year you will have 110 dollars, and you will earn 10 percent interest on the extra 10 dollars the following year, so by the next year you will have something like 121 dollars. You might be tempted to think ’so what, whats an extra dollar or two a year’. Don’t be fooled, the magic of compound interest is in its ability to take off and have a snowball effect that could eventually give you your financial freedom.
I told you that spending those few dollars here and there could be very costly to you in the future, and I know you still don’t believe me. I don’t know how better to explain this than with a simple example.
Tom and Bob were best friends, they did everything together. But, they had a few differences when it came to money. Every time Tom saw a chocolate bar or a piece of candy in the supermarket that he wanted to buy, he saved the dollar and at the end of every month, he put all his saved dollars into a very conservative investment fund that was earning him 10 percent per anum. Bob, on the other hand, had a great job and he didn’t see the need to ‘live like a pauper’, instead, when he saw something that he craved he would just buy it, after all, a dollar here and there never hurt anyone. By the end of every month, Tom managed to save about 100 dollars, and Bob was spending his 100 on snacks. Lets see what happened.
At the end of 10 years Bob’s little habit of spending a dollar here or there cost him about 7,500 dollars. How do I know this, its simple, Tom had managed to accumulate 19,500 dollars from his savings, but he only saved 12,000 dollars. Compound interest made 7,500 dollars for Tom, and by spending little money here and there, Bob had managed to spend 19,500 dollars of potential money even though he only spent 12,000 dollars of real money.
Thats not all, if Tom wants to start lightening up on his strict saving habits, and he stops putting money in all together, this is what happens.
Another 10 years go by, Tom goes to check up on his long forgotten investment. To his surprise, he finds out that, without saving anything for the past 10 years, his investment has grown to 50,580 dollars. WOW. In the past 10 years, compound interest made 31,080 dollars, as opposed to the first 10 years where it only made him 7,500 dollars. He can’t wait for the next 10 years.
All this happened without Tom having to raise a finger to work, it happened whether he was sick or asleep. If he wants to, he can start living off the interest and retire. Or he can wait a little longer, and retire in style.
Every second you wait, is a second that could be making money for you. Don’t make that mistake.
Simon
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Filed under: Money and Finances by Simon Rodrigues
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