Compound Interest

There’s a great thing that you might be unaware of and that is compound interest. Compound interest is a powerful thing. The way it works is that when you save money you earn interest on the principal and the interest.

Let’s define principal. Principal means the money you put (save) into an investment instrument, savings account, money market account, etc. The first month you save money, you’ll earn interest on your initial investment. This is referred to as a return on investment (ROI). The next month, you earn interest on your original investment and on the interest that you earned last month. Every single month, you interest on all the money you’ve saved and on all the interest the financial institution pays you. You’re earning interest on the interest!

However, compound interest will not work unless we develop one thing. We must develop discipline. You need to discipline yourself to save. We are not naturally prone to save. Therefore, we need to train ourselves to save. The Bible talks about discipline.

Hebrews 12:11 – “No discipline seems pleasant at the time, but painful. Later on, however, it produces a harvest of righteousness and peace for those who have been trained by it.”

It’s certainly not pleasant to do something like exercising or saving, but in time it will produce the desired results. If you train yourself to save money, then when you need it, the money will be there. As they say in the military and in law enforcement, “On your six.” That means it’s got your back. It’s there and it’s ready to cover you. This is like your O-line (Emergency Fund) it is ready to protect you from emergencies.

As you start to save and learn to handle your money, you are going to discover that it is a long process. You can’t do it fast. Look at Proverbs 21:5:

 “Steady plodding brings prosperity; hasty speculation brings poverty. “ 

You want to be like the tortoise in the story of “The Tortoise and the Hare.”

Go slow and be consistent. There’s no get rich quick. Get rich quick is a scheme. It is not a real. You cannot go and buy the latest scheme advertised on TV that says you’ll make a lot of money fast in foreclosed properties or whatever else they are touting. Making a lot of money is not easy and it’s not fast. If it was, there wouldn’t be any poverty or money struggles in the world. It is hard and it takes time. If anyone tells you different, they’re wrong.

Many of us have cable TV or satellite TV and we like to eat out. Let’s say that we decided we were going to save the money we spend on cable and eating out. This might about to about $150 a month. You invest that money in a mutual fund. Because interest rates are low right now, I am going to be conservative and say you are going to earn only 6% on average for the next 40 years.

At the end of that 40 years, you’ll have $298,724. No, it’s not a million dollars, but it’s a nice amount for just putting away $150. The amount will probably be higher because interest rates go up. My point is that money grows in time because of compound interest. The sooner you start and the younger you start, the better off you’ll be in the long run.

Did you know that if you are a smoker you are literally burning up your money? A pack of cigarettes ranges from $4.96 in Kentucky to $14.50 in New York. Let’s take an average of these two figures. It’s $9.73 per pack. If you smoke a pack a day, you are burning up $68.11 a week. Now, take the $68.11 and multiply that by 52 weeks, you are burning up $3,541.72 a year. What happens if you were to invest that money monthly ($272) at the 6% we were talking about for 40 years?

You would have burned up $541,685! This is what is known as the true cost of consumption. When you do this calculation, you are in essence figuring out how much your current expense is truly costing you long-term. Keep in mind that we are using a low interest rate for our calculation. The higher the interest rate, the more money you will have long-term. What do you think happens if we were to double our interest rate from 6% to 12%? You might think wow that means I would have over $1 million. You would be wrong. If the interest rate is doubled, you actually would have $3,200,018!  That is the power of compound interest.

What happens if we calculate the $150 a month at 12%, our eating out and cable TV money, we would have $1,764,716! When you have compound interest working for you your money is growing. Doesn’t this make you want to save? Compound Interest is you best friend when it comes to saving.

I know that savings accounts and Certificates of Deposits (CD’s) are not paying out 6% much less 12%. However, there are some mutual funds out there that have averaged a rate of return of 12%. However, you also have to factor in the rate of inflation in order to get your true rate of return. I’ll talk more about this and mutual funds in our investing lesson.i

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