When my first salary hit my account, I had two distinct emotions. The first emotion was excitement. Excitement because, after a year and half of accruing no income while I was in school, I was finally earning some coin. All hail the MULA. My second emotion was a little more complex; worry. Worry because I needed to figure out how to optimize my salary, do I buy a new car, a house, increase my credit card limit, join a gym, eat only organic foods, travel (well that’s out the door now), the list is endless. But I realized that I was not interested in becoming rich, I wanted to create generational wealth. So how do I achieve that?
While there are various ways to do this; including creating multiple streams of income and saving 80% of my earnings while living like a caveman, one thing was crucial, and this thing is referred to by thinkers as the 8th wonder of the world: Compound Interest. In this blog I will break compound interest down to its nitty gritty and then we will rebuild in consequent blogs, because I believe that understanding the fundamentals is essential to creating a sustainable financial strategy.
Compound interest is so important that it could solidify or devastate your financial future. This is because money in a great portfolio given time grows not progressively but exponentially. This draws an absolute parallel to seed in good soil becoming a tree with multiple fruits given time (the scientist in me is screaming “all things being equal”). Truly understanding this simple equation will unravel the secrets to wealth. How then do I put compound interest to work?
Firstly compound interest is an equal opportunity wonder, it will do to your debt what it will do to your investments/ savings. What this means is that if you owe $100 with a 10% interest rate for ten years, at the end of the 10 years you would have paid $259.37, the same is the case if you invested $100 you would have a total investment of $259.37. Yes, I know this is elementary school math, but its effects are worth paying attention to because it suggests the levers that you have in your arsenal to manipulate when making financial decisions.
- Monthly deposit
- Interest rates
- Duration of debt/investment/savings
Let’s talk about the principal and monthly deposit for a moment. If you have a principal of $100 as in the example above, then your interest earned at the end of 10 years is $159.37. But what if you add $1 monthly, your total contribution will be $220 ($100 principal + $120 monthly deposit) and the total size of your investment will be $460.83. This is crucial because it highlights the importance of consistent payment as it improves your investments significantly, and in most cases, that amount paid as a monthly deposit is not life-ending, and it’s probably money you would have squandered. It also optimizes your financial growth within the same duration.
Yield is the return on your investment, so for an investment portfolio, the yield is the dividend paid annually, in a real estate investment your yield is your rental income and the increase in the price of your investment. For this article, I will consider yield to be a dividend, rental income, and such. This is important because it introduces the idea of passive income or cash flow (if you are an MBA head like me). My money making money in my sleep isn’t that the dream (pun intended). While yield is not part of the compound interest equation it is important to include it here, because it introduces reinvestment opportunities like DRIP (dividend reinvestment plan) and using rental income as a mortgage for other rental properties, hence multiplying wealth. When considering investment opportunities, the yield rate is a good KPI to investigate.
The almighty interest rate, economies have been built and dismantled on the hills of interest rates, an increase in interest rates determines whether it’s time to buy, sell, or refinance a home as a 1% increase in rate equals a 10% dip in home prices. When deciding on which stock or portfolio to buy, we consider the interest rates, low interest rates are associated with less risky opportunities like bonds and treasury bills while high-interest rates are associated with more risky opportunities like day trading. Lenders will decide on your interest rate level based on your credit scores because it is an indicator of the risk they are taking by lending to you. If your credit score is high, it indicates that you will make your repayments as it comes due and vice-versa.
While undoubtedly interest rates are important, time or duration is just as important a lever in compound interest as the interest rate is. Duration which is the number of years of the investment/debt repayment is the exponential factor in the compound interest equation, hence the most important factor to consider when making financial decisions. Imagine you took a $50,000 student loan at 6% for a 15-year duration, at the end of the 15 years, you would have paid $119,827.91 in total to your lender. But if you decide to pay in 5 years instead, the total paid at the end of five years will be $66,911.28 which is a variance (Savings) of a whooping $52,916.63 this to me is magic. It drives home the saying that “Time is money” doesn’t it?
Let’s do the same with the interest rate and reduce the rate to 2% for 15 years, the total paid at the end of 15 years will be $67,293,42. While this is a little higher than a reduced duration, it is not significant, what is however significant is the power you have to determine the duration of your debt versus negotiating your interest rates. Regardless of how low or high your rates are, if you can pay them fast enough, you can reduce your cost of financing significantly. For investment, interest rates is solely dependent on how risky you are.
I am sure you are thinking to yourself “hmm, how do you harness the 8th wonder of the world?”
- Pay debt as fast as possible, if the interest rate on your debts is higher than the interest rate on your investments, don’t bother investing, otherwise, you are playing a negative-sum game. Your debt repayment at this point is your investment.
- Keep your credit score in the 700 range to be eligible for low-interest rates when applying for lines of credit
- Consider long-term investment opportunities, especially if you are not investment savvy.
- Consider a portfolio mix of low and high-risk investments for balance. Also spread your investment across multiple sectors, regions, and economies
- Using government investment vehicles such as RRSPs, TFSA, and RESP if you have children. etc
So the road to building generational wealth is paved with negotiations on interest rates, estimating the duration of repayment/ investments and picking the right strategy… Good to know!.
Now that we know all the levers for financial freedom, in the coming blogs will deep-dive into debt payment strategies, investment opportunities and vehicles, credit strategy and building financial freedom mindset.
Lets start a dialogue, what are your thought on compound interest and how to manipulate it to harness its best powers!