011 // Not All Compound Interest is Created Equal
Invest In Your Life
Long-term compounding illustrated
Sam walks John’s $1,000 through multiple doubling cycles to show exponential growth over decades.
There are two types of people in this world. There are people who understand compound interest and take advantage of it, and there are people who get taken advantage of by it. Sam talks about how there aren't a lot of people who really understand what compound interest is or how to really use its power.
Einstein referred to compound interest as the 8th wonder of the world. The person who understands it, earns it. The one who doesn't will pay it. Sam breaks down ways people avoid compound interest and shares an example to illustrate how it works. This episode will help encourage all of us to take advantage of this powerful tool.
Episode Highlights:
[02:35] Who gets taken advantage of by compound interest? We think of credit cards and personal loans with high interest rates.
[03:15] There's also an opportunity cost of avoiding things, such as avoiding investing or saving and missing out on compound interest.
[03:47] Sam shares an example to illustrate compound interest.
[04:07] The rule of 72 tells us how long it will take our money to double. You divide 72 by your expected rate of return and you get an average of how long it takes to double your money.
[05:35] We're going to use a 10% rate of return and divide 72 by 10. With this calculation, his money will double every 7 years. At first it's not that big of a gain, but as the cycle repeats his money grows exponentially.
[08:23] It's not difficult to see how significant this growth can be when you add money over time.
[08:52] What's your biggest asset? People often overlook how time is one of our biggest assets.
[09:33] According to James, we'll take time and time takes time. Time is one of our biggest assets.
[09:58] Most people save in a retirement account that's either a Roth account or a traditional account. Traditional retirement accounts get a tax break when you pay into it, and you don't pay taxes until you withdraw the money.
[10:39] With a Roth IRA you invest after paying the taxes on the money. The money grows tax-free, and it's tax-free when you take it out.
[11:13] If John contributed $1,000, and has 127,000 of market growth would he want it to be tax-free or tax upon withdrawal? There are pros and cons to each scenario but thinking about it this way is a helpful starting point.
[11:55] This just illustrates that all compound interest isn't created equal.
[12:14] Compound interest can also add significant estate planning issues. All of these things need to be thought through. Proper planning is the key.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark, and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board's initial and ongoing certification requirements.
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