Apply the secret of compounding to debt and savingsNoel Whittaker
Published: February 9 2018 - 12:49PM
Last week's column about investing $2.83 a day for a child attracted a flood of emails. The main queries were along the lines of "How can I obtain a safe 9 per cent annual return?", "How do I start?" and "What about the impact of fees, tax and inflation?"
These are all important questions, and because this topic is of critical importance to anybody who wants to build wealth, I will devote the next three articles to explaining it in more depth.
Just keep in mind that last week's article was in the nature of a parable: its aim was to teach wealth building fundamentals in a simple way. So don't worry too much about the rates of return, or tax at this stage, just focus on the basic principles.
Today, I will start with the theory of compounding and explain how the maths works. Next week we will discuss the kind of investments that can produce the returns I have written about, and finally we will discuss the impact of fees, tax and inflation.
Albert Einstein called compound interest "the eighth miracle of the world" because its effects really do appear miraculous. It's a simple concept: when you let the earnings on an investment compound, you leave them to grow instead of withdrawing them.
Now, compounding might seem like a miracle in its later years, but it is slow to start. This is why it can be hard for us mere mortals to put into practice – for the first few years nothing seems to happen, and the temptation is to think nothing is going to happen and stop the investment program.
Compounding works for both investing and borrowing. The two main factors that influence the amount of money you can accumulate, or the amount of time it takes to pay off a loan, are time and rate. But note well that if the time is short the rate doesn't matter much.
If you decide to buy a car for $15,000, borrow the whole lot, and pay it back over 12 months, the rate is almost immaterial. At an interest rate of 7 per cent, the total interest will be $576, at 10 per cent it would be $828.
It works the same with your housing loan. If you owed $400,000 at 6 per cent over 30 years, your repayments would be $2398 a month. After five years, you would have made repayments totalling $143,880 but would only have reduced the loan by $28,000 – you would still have 25 years left to go.
However, if you found the resources to double the repayments to $4796 a month from the outset, the term would be slashed to just nine years, saving $431,000 in interest. This is why home owners who focus on getting their home loan paid back quickly end up better off in the long-term. They are not wasting money on non-deductible interest
It's the same if you're investing: invest $1000 a year for two years at 4 per cent and the balance at the end of the term would be $2040. If you doubled the rate of return to 8 per cent the balance would be just $2080. Because the term is short the rate is not that important.
But the outcome is dramatic if we can increase the rate of return at the same time as we increase the time frame.
Invest $1000 a year for 50 years at 4 per cent, and the balance at the end of the period would be just $153,000. If you double the rate of return to 8 per cent the balance would be $574,000.
Let's go back to investing $2.83 a day, which is the equivalent of $1000 a year. It is obvious that nothing would be lost by putting the money into a low interest savings account until it reached $2000 and then investing that. This, of course, assumes you have the discipline to accumulate that lump sum.
Think about a person who has $100,000 to invest, and who manages to achieve 9 per cent a year. At that rate the portfolio will double every eight years. They will have $200,000 after eight years, 400,000 after 16 years, $800,000 after 24 years, $1.6 million after 32 years and $3.2 million after 40 years. Notice that every time their portfolio doubles, there is more growth in the last double than in all the previous doubles added up. This is a graphic example of the importance of time on an investment program.
Now that you have an elemental knowledge of compounding, let's look at ways you can make it work for you. If you have a non-deductible loan such as your home loan, try to speed up your repayments; if you are taking out a personal loan, make sure it's on the shortest possible term. If you have superannuation, look at the asset allocation to make sure it targets the maximum possible return that would suit your goals and your risk profile. These are just starter ideas, but each one could be worth a lot of money to you.
Looking forward to continuing our dialogue next week.
Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. Email: email@example.com
This story was found at: http://www.canberratimes.com.au/money/investing/apply-the-secret-of-compounding-to-debt-and-savings-20180209-h0vtxk.html