3 hacks to beat the banks and get even with Compound Interest
I'm compounding daily
“Everything is significant yet nothing is significant”
Listen (or download) to the post here. After you listen, please let me know what little things you do daily that compounds, for me it brushing my teeth :)
Today has been such a challenge, I mean just getting through the day. I had and still have 101 things to do including finishing my breakfast (even though it is 9 pm right now). My children were extra active today and I am extra tired. Plus my favourite TV show is on and I really want to watch it! But this post goes out today and ironically we are discussing compounding.
So a thought just crossed my mind though, “what if I postpone this post till tomorrow?”, no one would mind, right? Would you? Maybe you wouldn’t if I gave you a detailed list of all the things that haven’t gone to plan this week. My reasons would probably be more justifiable.
But when I look at ‘living a good life’ and ‘building wealth’ as a series of mini “insignificant” decisions, I understand more clearly why no one-thing is significant in itself yet everything (every little action) is significant when looked at together. This is because of the power of compounding. Every decision compounds on the previous decision. This means our daily decisions (whether significant or insignificant) brings us closer to or farther away from financial independence.
Consequences matter, even when excuses are justifiable
Decisions (which are legal and moral) are neither bad nor good, however every decision we make or don’t make has a consequence. Deciding to start investing now or to wait a bit longer, deciding to study or to watch TV. No one decision in itself seems more significant or life-changing. But these little actions build upon each other. Initially, they will have a small effect but with time, the cumulative compounding effect will lead to a very significant result.
Because of this, I am up typing and retyping this post against my current feelings, because I know the little things matter.
“Good and evil increase at compound interest. That’s why the little decisions we make every day are of infinite importance.”
But what does this have to do with your money?
By far the most important two words when it comes to investing in the stock market or getting a loan are the words “compound interest”. It is the reason why many people today are rich and why many more are in huge unwanted debt.
What does it really mean? And is it that important?
Compound interest means “interest on interest”. It is the way to build wealth from little cash based on the interest rate and time. We can see the effect of compound interest when we earn interest on our savings and we reinvest that interest earned in addition to the initial amount invested. As we keep reinvesting the interest earned, our money will continue to grow. It will eventually double and continue growing. In other words, as long as you stay invested, your money will be your employee going to work and bringing you daily profits.
For example (ignoring tax and interest rate fluctuations) if you deposit £10,000 into an investment account which paid 8% interest per year.
After year 1 you would earn £800 payment in interest. At the start of year 2, you would now have £10,800 as your new balance. A further 8% interest will give you a payment of £864. And by year 3 you will be earning 8% on £11,664 (10800+864).
3 Hacks to help you get even using Compound Interest
Hack #1: Frequency of compounding
It was January 2016, 4 months after the birth of my first child. My sister in law and I were committed to toning up our tummy muscles ahead of our family holiday. We wanted ‘beach bodies” (don’t judge me) so we worked out every day for 4 months. And we achieved our goal. It was hard, uncomfortable and painful, but I was motivated. I woke up early each day and did between 10 to 20 mins of exercise every day. And the days I didn't feel like doing anything I would just stretch. Had I done my exercises once a month, or once a week I might not have achieved my goal as quickly as I did. Why? Well because frequency matters in all areas of life just as it does when building wealth. Doing small things often matter, saving and investing often also matters.
The frequency of compounding on your account (investments and debts) i.e. how often the interest on your account is calculated has an effect on how fast your money grows. The more frequently the compounding the faster your money grows. If your money compounds annually, it means that your interest is calculated once a year. If your money compounds monthly it means your interest will be calculated 12 times a year, and in some cases, money compounds daily, in these cases your interest will be calculated on a daily basis. We used annual compounding in our example, in practice, compound interest is often calculated more frequently (quarterly, monthly, or daily). The compounding frequency makes a difference - specifically, more frequent compounding leads to faster growth. For example, have a look at the table below showing the growth of £10,000 at 8% interest compounded at different frequencies.
Hack #2: Rate of return
Here is a perfect example adapted from the book Making Money made simple by Noel Whittaker.
If you saved £10k only and invested it at 8% compounding each year it would build up to £46,610 in 20 years. However if you saved the same £10k and invested it for the same 20 years, but this time at a new rate of 16% which is double the initial rate. Although we would logically assume that by doubling the interest rate, we would double the resulting amount, however, because of the beauty of compound interest, we would more than quadruple our potential payout to £194,607.
In the same way, high-interest debt such as credit card debt will grow much faster than low-interest debt such as student loans or mortgages.
It is important to remember that stock market investment rates can go up or down. But it tends to average out when you leave your money invested for a long time. This post is for information purposes only and should not serve as professional financial advice.
Hack #3: Time
When it comes to compound interest and investing in the stock market, time is your best ally. The sooner you can start investing the more time you will have to grow your money. Just like when I started working out, I didn’t see the results immediately. All I felt was unspeakable pain from my achy muscles. But as I kept doing the workouts, after a period of time I began to see the results I hoped for. The same principle applies to investing. With time on your side, you can very easily build wealth from little.
Imagine again you invest £10k at 8% for 20 years and you get a return of £46,610. Keeping it invested longer for a further 5 years to 25 years will increase your return by 47% (that is almost 50% increase) to £68,484 in 5 years!
This can also be applied to the length of time you hold on to any debt.
“Compound interest on debt was the banker’s greatest invention, to capture, and enslave, a productive society.”
In summary, use compound interest to your benefit by
Investing frequently even if you have little cash.
Keep your money where it will grow, savings account offer very low interest rate.
Leave your money invested for the long term.
Hoping you understand the power of compound interest, if you would like to know more you may read my more detailed post about the Beauty and Beast nature of compound interest.
In the meantime, do tell me what little things you do every day that might seem insignificant because you do not see the result right away but you know that all your little actions will compound into one big glorious result one day. For me it’s brushing my teeth, and reading picture books with my kids. What’s yours?
Does all this sound a bit “goobuligook”? Like a different language?
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