Learn How You Can Benefit From The Use of Compounding
In recent months (Winter 2013) we have had an increase in the number of questions regarding the topic of compounding and in this discussion we will address exactly what compounding is and how you can use it in your life to achieve the goals that will serve your and your family’s best long-term interest.
What Exactly is Compounding?
First and foremost it is important that you realize that interest is either:
1) Simple, or
Simple Interest is a quick method of calculating the interest charge on a loan or the interest that will be earned on an investment. Simple interest is determined by multiplying the interest rate by the principal—by the number of periods.
Simple interest is quite easy to understand as it is simply calculated as follows:
$1,000 at 7% interest is equal to $70 dollars in interest on an annual basis!
Over a 20 year period with simple interest you would accumulate ($70 times 20 years) $1,400!
Now let’s look at COMPOUNDING…
Compound interest is when interest is added to the principal of a deposit, investment or loan, so that, from that moment on, the interest that has been added also earns interest.
Compound interest is often misunderstood by many and it is calculated as follows (you need a financial calculator to compute):
$1,000 compounded annually at 7% for 20 years and you were to reinvest the interest you would accumulate roughly $3,870—a difference of ($3,870 minus $1,400) $2,570 from the "simple interest" that you would receive over the same 20 year time period!
Now let's look at $10,000 invested over a 20 year period at 7% interest using both SIMPLE and COMPOUND Interest...
$10,000 at 7% interest is equal to $700 dollars in interest with simple interest on an annual basis and over a 20 year period you would accumulate $14,000!
$10,000 compounded annually at 7% for 20 years and you were to reinvest the interest you would accumulate roughly $38,700—a difference of ($38,700 minus $14,000) $24,700 over a 20 year period!
Now you get the picture…
If the above returns were inside of your retirement account such as an IRA, 457, 403b, Thrift Savings Plan or 401k—no taxes would be due on an annual basis (you can have the following inside of your retirement account(s): bank CD, Money Market Account, Bond Fund, Stocks, or Mutual Fund etc..
If the above returns were outside of your retirement account such as in a bank CD, Money Market Account, Bond Fund, Stocks, or Mutual Fund etcetera, taxes would be due on an annual basis. Interest, dividends and capital gains would possibly be taxable.
Your emergency fund balance would be considered "outside of your retirement account" and the interest earned would be taxable on a yearly basis, however with savings and money market interest rates so low at this time (January 2014) the taxes would be very low.
The key point to remember is that your money will grow at a faster rate if left untouched and the interest is compounded over time!
If you continue to add money to the investment—over time your returns will be even larger over time!
Therefore, as part of your long-term strategy you must come up with ways that you can invest both inside and outside of your retirement accounts at a level that will take you to where you need or want to be during your retirement years and beyond.
All of that sounds great—but where will I find the money to invest over time I barely have enough to live on?
You must first determine where you are at financially by doing at a minimum the following:
3) You must properly establish an emergency fund
If you can
come up with a way to get just an additional $80 or so a month after or while you have
addressed the above—after a 20 year period at 7% interest compounded monthly you
could have over $40,000 in those account(s)!
If you could come up with a way to get an additional $800 per month—after 20 years at 7% interest compounded monthly you could have over $400,000 in the account(s).
If the investments were inside a ROTH IRA you would be able to withdraw the contributions tax free at any time—as taxes on the "contributions" have already been paid. If over age 59 1/2 you could withdraw the contributions and earnings tax free (certain restrictions apply).
If the contributions were made to a Traditional IRA you could deduct the contributions on your taxes on a yearly basis up to a limit (certain restrictions apply).
Once you withdrew the contributions and earnings during your retirement years you would pay taxes (you would normally be in a lower tax bracket) after age 59 1/2.
If you withdrew early (before age 59 1/2) there would be taxes on withdrawal and a 10% early withdrawal penalty unless an exception was applicable.
If you have a family of 5 you could possibly save $80 or so on a monthly basis by going to coupons.com and smartsource.com and use coupons on items you normally buy and possibly save $80 or more per month.
You could possibly cut your energy costs by changing over to fluorescent light bulbs, installing an electronic setback thermostat, sealing air pockets in your home, sealing gaps in your home with insulation, insulating your hot water pipes and that too could possibly free up an additional $80 or so per month.
The opportunities for coming up with additional revenue are unlimited and you must use your imagination and your creativity to come up with more income or reduce your current monthly expenses on a consistent basis (or do a combination of the two)!
Compounding is one of the simplest and least painful ways that you can utilize to help you reach your future goals in a more time efficient manner.
The key is to get yourself and your family in a ”favorable financial position” by addressing your credit and finances in a critical manner on the front end.
Once you do that you can position yourself and your family properly so that you can invest for the future in a manner that can be of greater benefit!
Whether you are investing inside or outside of your retirement accounts you want to be in position to use the power of compounding to your and your family’s best advantage.
Always realize that you may have to get additional income and/or cut your expenses in order to achieve your desired goals!
When you invest you must be conscious of what is occurring! When an investment earns interest or dividends your total amount invested increases.
That increased amount earns even more interest or compounds (if left alone) and the cycle continues as long as you don’t pull out cash.
Be sure that you know the compounding frequency—the more frequent the compounding the more you will earn!
Monthly compounding is better than quarterly—daily compounding is better than monthly and so on…
invest on a continuous basis and/or increase the amount the growth rate will be
even more than if you did not do so!
Keep in mind that certain types of investments could lose value (stocks, bonds, Mutual funds etc.)—that is why it is important that you know how to invest in a manner that serves your and your family’s best long-term interest (you must know the risk, time-horizon and other factors that may be unique to you and your family).
You must also realize that inflation will always raise its ugly head, therefore be sure to factor that in as your buying power will be negatively affected over time.
We wish you untold success in your future and we are of the opinion that you will find a way to make compounding work for you and your family—not against (creditor's use of compounding to their benefit due to your unwise use of credit) you and your family!
It is important that you realize that credit card companies, consumer lending companies and other creditors use compounding to their benefit and to your detriment. Therefore if you currently have credit card or other outstanding debt you must come up with a plan to reduce or eliminate that debt now!