Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
– Albert Einstein
I am assuming you already know this, but compound interest is so fundamental, so crucial, so important, I have to cover it. Financial freedom is simply a product of: amount of money invested, rate of return, time, and inflation.
#1 – Invest Money
It goes without saying that you must invest money to become financially free. It isn’t saving money that makes you wealthy, it is investing money that will result in you being financially free. I recently heard a story of a guy who invested for 30 years and has millions. He now lives, essentially tax-free, by borrowing money (debt) and using his investment account as collateral for the borrowed money. Borrowed money is not included in your gross income for tax purposes. His other option would be selling shares of stock, paying capital gains, and keeping the difference. This is genius, and is the product of investing money for a long period of time. His only real expense is the interest expense of 2%-3% which is much lower than the capital gains rate of 20% and results in a deduction for his investment interest expense (against his net investment income, if any).
#2 – Rate of Return
Since 1945, the S&P 500 has returned about 11% per year. If you adjust for inflation, the after-inflation rate of return was about 7.1%. Obviously, the higher the better.
#3 – Time
The longer your investments can compound and grow, the more dollars you will have. Let’s run some numbers. Let’s assume you are going to invest $1,200 per year, and you will increase that each year by 4%. You will start at age 18. You will earn 11% per year and inflation will run at 2.5%.
How much will you have at age 65? $2.08 Million dollars!!! The total amount you would have invested of your own money would have been only $159,534. The other almost $2M was all investment gains. Now, there’s a pretty good chance you’ll lose some of that to taxes, but with good planning you can significantly reduce the impact of the taxes (see above re: borrowing against your portfolio).
Ok, let’s do the same exercise but assume you start at age 25 – just 7 years later. How much do you have at 65? $975,597 – a little disappointing to know that had you started 7 years sooner you’d be more than twice as rich.
The point is that time is essential to growing your wealth. The later you start the more you must save, and as we saw above, you must save a lot more if you start later. So get going!
#4 – Inflation & Taxes
Ok, so inflation is best illustrated by McDonald’s hamburgers. When I was a kid, on Wednesdays you could buy a hamburger for $0.29. Now, I am pretty sure a hamburger is more than $1.00. The point is that the cost of goods such as food, fuel, plane tickets, tuition, and sweaters tends to increase over time.
A measure of inflation is the consumer price index. Typically, financial advisors will factor inflation at 3%. However, since the great recession of late 2007 through early 2009, inflation has remained low. In fact, the inflation rate according to the Consumer Price Index over the last 12 months is only 1.6%.
High inflation reduces the number of Playstation games I can buy for $100. Negative inflation actually increases the number of Playstation games I can buy for $100.
With respect to taxes, suffice it to say that we want to minimize or eliminate taxes. Tax-free growth can be achieved through the use of IRAs, retirement plans, and health savings accounts. Minimizing taxes is essential to growing wealth. Stay tuned because I am going to cover IRAs, retirement plans, and health savings accounts in my series on the Five Pillars of Financial Freedom. If you haven’t been following that series, check out the intro and part one on avoiding bad debt.
I want you to start thinking when you go to buy things about the lost opportunity of not investing your money in something that will grow or create value. You might think, “it’s only $10.” However, $10 compounded at 11% per year for the next 30 years is really $228.00. Make it a $100 expense and we are talking about a few thousand dollars. Make it a little $2,000 vacation and we are talking almost $50,000!!! If you want to become wealthy, think about every dollar in light of what that dollar could turn into over a given period of time invested at a certain rate of return. Something I do to help me prioritize the future over the present is to mentally picture my daughters before I buy something. That helps me to say no to things I really don’t need in favor of saying yes to my daughters and their future financial needs (college, weddings, etc.)
Invest early and often!