Put yourself on the right side of compound interest
One of the important steps towards sorting out your finances is to make sure that you take full advantage of the miracle of compound returns, but simply understanding how it works is not enough. You must live it.
Albert Einstein said: “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
Not everyone understands like an Einstein. So let’s look at a case study: call her Credit Card Kelly.
Once upon a time, there was a girl name Kelly. She was a lovely lady who loved life. She decided she was going to start a savings plan and take full advantage of living as an expat in the UAE.
Kelly was lucky. She got a huge bonus of Dh120,000. She was delighted, as she had a nasty little debt which had grown and grown. It was an honest debt; not due to frivolous spending on clothing but rather a loan for her rent which was due 12 months in advance.
The problem was, she didn’t pay it off straight away, opting for a fun weekend here and there. So her Dh80,000 loan turned into Dh100,000 and then Dh120,000. This is what happens when you don’t keep up with your repayments.
Lucky for Kelly, she got a bonus and paid off her debt. She promised herself that she would make changes and learn from her mistake. She was going to invest Dh7,500 a month for her retirement.
But she was running late meeting her financial adviser and cancelled the appointment, deciding instead to pop into Jimmy Choo where she found a pair of shoes on sale. Given her good luck, she decided to reward herself for paying off her loan and buy the shoes before she started saving.
And so began the pattern again.
And just like before, her credit card debt grew. Kelly, ashamed of her mounting debt, never met her adviser again. She buried her head in the sand. That was 2008. Had Kelly met her savings plan, her investment would have grown over the past few years. And if you think about that Dh7,500 over 48 months – not even taking growth into account, she would have saved Dh360,000 by now.
Instead Kelly continued to buy shoes and is again Dh120,000 in debt on her credit card.
Now do you want to understand the power of compound interest?
Let’s take a look here ...
When people talk about compound interest, more often than not, they talk about it working in your favour. The harsh reality is that compound interest also works against you if it’s on your credit card. Credit card debt can be incredibly destructive.
If you knew the top you were buying was not Dh1,000 but in actual fact Dh5,000 by the time you had truly paid for it (when you finally paid off your credit card), would you ever have bought it?
This is how compound interest works against you. It is imperative for a smart shopper to understand this.
One of the first steps towards sorting things out, is to make sure that you take advantage of the miracle of compound returns. Get your credit card out of sight and make your money work for you. The beauty of compound interest is that the rules don’t automatically change when you start playing for the other team – they remain the same.
Do you know the interest rate on your credit card or the amount it changes over time?
The scenario below illustrates compound interest. If you were given a choice to receive a million dollars in a month or a penny doubled every day for 30 days, which one would you choose? Let’s take a look at the calculations.
Day 1: $.01
Day 2: $.02
Day 3: $.04
Day 4: $.08
Day 5: $.16
Day 6: $.32
Day 7: $.64
Day 8: $1.28
Day 9: $2.56
Day 10: $5.12
Day 11: $10.24
Day 12: $20.48
Day 13: $40.96
Day 14: $81.92
Day 15: $163.84
Day 16: $327.68
Day 17: $655.36
Day 18: $1,310.72
Day 19: $2,621.44
Day 20: $5,242.88
Day 21: $10,485.76
Day 22: $20,971.52
Day 23: $41,943.04
Day 24: $83,886.08
Day 25: $167,772.16
Day 26: $335,544.32
Day 27: $671,088.64
Day 28: $1,342,177.28
Day 29: $2,684,354.56
Day 30: $5,368,709.12
Now what happens when we move from day 30 to 31? Yes, it doubles.
Day 31: $10, 737,418.24
That’s a pretty powerful penny.
The moral of this story is that investment is not about market timing, it is more about time in the market.
Janelle Malone is a wealth commentator, writer and author. You can read her blog at www.womenmoneyandstyle.com
Updated: October 5, 2013 04:00 AM