One of the first topics covered in almost every personal finance book you read is the power of compound interest.
Compound Interest 101
You can skip this section if you are already familiar with compound interest and how it works. I’m including it for people new to the idea.
Let’s say you have access to a savings account that earns 5% interest. You decide to put down $1,000 and lay it aside for future emergencies. To simplify the calculations, we’ll say it’s compounded annually (meaning you only calculate interest once a year).
At the end of the first year, this account contains $1,050. You have your original $1,000, plus you have 5% interest on it – $50.
At the end of the second year, the account now contains $1,102.50. You have the $1,050 you had after the first year, but this year it earned more interest – $52.50. Why? Interest earned in the first year is now himself earn interest. You didn’t just earn interest on the first $1,000. You also earned it on the first year’s $50 interest, which is $2.50 more.
At the end of the third year, the account now contains $1,157.63. You have the $1,102.50 from the end of year two, but this year it earned $55.13 in interest.
Now, from year one to year two, your interest has gone from $50 to $52.50, an increase of $2.50. From the second to the third year, your interest has actually increased even more – going from $52.50 to $55.13 represents an increase in interest of $2.63. Not only does the amount of interest increase from year to year, but the amount it increases each year is actually increasing.
After five years, you would have $1,276.28 in the account.
After ten years, you would have $1,628.90 in the account.
After twenty years, you would have $2,653.30 in the account. Your money has more than doubled without you lifting a finger, and each year the money has grown more than the year before.
This is the power of compound interest. It’s not impressive at first, but if you stick with it, it becomes a powerhouse.
Compound interest is great, but there’s a catch
What’s the catch? In order to truly harness the power of compound interest, you need to let your money rest for a long duration.
In the example above, your money has doubled after about fourteen years. Sure, it’s great that your money doubled, but it took fourteen years old for him to do so. It’s a long time. Think about where your life was fourteen years ago.
I was in my second year of university. I was dating the woman I was going to marry. I had only met one of the few people who would help me build my first career. my life was completely different.
The seeds of success today were planted in this completely different life.
If you really want your money to impact your life, you shouldn’t start with investments.
The first thing to do when you have money to put aside for the future is to assess your goals. What do you want from your life? What are your dreams? Your hopes for the future?
If things were going reasonably well, where would you really like your life to be next year? In five years? Ten years? Twenty years? At 65? These are the questions that should underline how you manage much of your money (apart from your basic invoices).
Of course, we spend some of our money on todaybut spending all your money on today means you are ensuring that tomorrow won’t be much better than today.
So how do you most effectively turn that little extra cash today into the better life you want tomorrow? There are many ways to do this – and not all of them can be found in the pages of a financial magazine.
Do you want a better – or at least different – career? The best way to get there is through education, and the best way to prepare for it is to put your money in a 529 college savings plan for yourself for a few years and then take that leap.
What if you want something that doesn’t seem directly related to finances, like better fitness? It requires an investment of time and energy, not so much the finances. They are also investments.
What if you want to be debt free so you don’t have the stress of monthly bills and your boss doesn’t have so much power over you? It takes an investment, but it’s in the form of lean living and extra debt repayments.
In each case, the first small step you take doesn’t make a big difference. A day of exercise does not change your physical condition. An additional debt payment does not change your debt situation. A small amount in a 529 alone does not make a new career.
Just like with compound interest, it’s the continuous steps that start to build on themselves. Exercise several times a week and it becomes easier and more rewarding. Make an extra debt payment each month and the debt starts to melt away faster and faster. The regular money in a 529 starts piling up, turning the dream of a new career into reality.
You can build the life you want. You just have to figure out what you want, then take action each day to make that life happen, whether it’s a financial step, an energy step, a time commitment step, or something else. The more steps you take, the easier they become, and the more your efforts begin to pay off beyond what you expected.
Almost every success you have in life is an investment. Almost all success in life is built on the small steps you’ve taken, going beyond what you expected of them. A dollar in savings every day, a half hour of practicing a skill every day, an energy-intensive workout every day.
It all starts with the commitment to take those small steps and seeing a very small reward for those steps in the beginning. Do it over and over again and those successes start to get worse. Stick with it, and that investment will begin to pay off in a life-changing way.