It has been said that compound interest is the eighth wonder of the world. He who understands it earns it and he who doesn’t, pays it. As business owners, we have to understand compound interest and put it to work for us. If we don’t, it will most certainly put us to work for it. This is why I want to take some time today to discuss the value of investing and more specifically, the incredible earning power of compound interest.
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One of the most important aspects of compounding interest is time. What do I mean by that? Well, the longer that your investment has to earn interest, the greater the total return. There is a fantastic illustration of this that I came across on Dave Ramsey’s website. It tells the story of two friends that begin investing $2000 per year into accounts that yield an average annual interest rate of twelve percent. I’m not sure where they came up with such a lofty interest rate but for the sake of the illustration, we will stick with it.
One of the men begins investing $2000 per year when he is nineteen years old and continues until he is twenty-six. The other begins investing at the age of twenty-seven and continues until he reaches sixty-five years of age. The first invests just $16,000 while the other man invests a principle of $78,000. So who had more money when they both reached age sixty-five? The first man had $2.28MM because of compounding interest. The second man only earned $1.5MM. That is a huge difference, folks, and all because the first man began to invest earlier!
“On average, millionaires invest 20% of their household income each year. Their wealth isn’t measured by the amount they make each year, but by how they’ve saved and invested over time.” This is a quote from Ramit Sethi’s “I Will Teach You To Be Rich,” and when I first read that, I began to think about the investment habits of the average business owner. Think about it, if you make $100,000 per year, are you investing $20,000?
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Using the power of compounding interest can allow the project manager that makes $50,000 per year to become wealthier than the doctor or lawyer that earns $250,000 each year. It all comes down to how much you’re willing to invest and when you’re willing to do so. Understanding compound interest and putting it to work for you is the key to average people becoming millionaires. Now, this is entirely dependent upon when you began investing, how much you’ve invested, and your actual interest rate but it is possible for the interest to snowball in such a way.
By now, we’ve established that this thing takes time. Compound interest is a crockpot recipe so if you’re looking for a microwave dinner, this isn’t going to appeal to you. However, exhibiting patience with your investment is so worth it.
Not long after I became a financial advisor, I spoke with another advisor who asked me, “If I offered you a penny that doubled every day for thirty days or two-million dollars, which would you take?” Well, as they say, a bird in the hand is worth two in the bush. Right? Here’s the thing, if I chose the $2MM I would miss out on a little over $3MM.
Although it begins as a very slow process, you can see that the penny becomes more than 100% more valuable than the $2MM by the end of the thirty days. Simply by being patient, I could sit back and watch as my magic penny turns into $5,368,709.12. So which would you rather have, $2MM? or $5MM? As you can see, the numbers begin to exponentially increase the longer you’re in the market. I’ll say it again, investing requires patience.
The proof is in the pudding, folks. Compound interest yields a powerful return of investment. It is a very slow process but it yields results just the same. However, if you’re still not convinced of why you should invest, think of the enormous impact that it will have on your future generations.
One of the greatest stories I’ve ever heard about this subject is that of Benjamin Franklin. On July 17, 1788, Franklin drafted a will that combined his passion for civic virtue with his fascination with compounding interest. He realized that by creating a structured philanthropic trust, he could make small sums of money grow. Franklin created a trust that he designed to last exactly two hundred years.
Within this trust, Franklin gave a thousand pounds — that’s the equivalent of $100,000 as of 2008 — each to Philadelphia and to Boston. The funds were to be used to provide small loans to married men under the age of twenty-five who had completed an apprenticeship and wanted to start a business. The loans were given at a five percent annual interest rate. I mean, this was like the original Shark Tank, folks.
However, Franklin had also figured out how much the funds would grow over the next two hundred years and he specified that any additional funds could be used for civic improvements. He funded the building of roads, fortifications, and aqueducts long after his death. This made the lives of the people in the cities much more agreeable and made the cities more inviting to newcomers.
At the one-hundredth anniversary of Franklin’s microlending and municipal improvements project in 1890, the trust in Philadelphia contained roughly $100,000 — that’s $2.8 million as of 2008 — and the trust in Boston had swelled to $431,756 or $10.1 million in 2008.
Benjamin Franklin changed history but his use of compound interest isn’t often taught in school. Through thoughtful planning, investing, and the power of compound interest, Franklin changed cities and lives. It isn’t too late for you to put compounding interest to work for you. I encourage you to begin investing right away.
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