ENCOURAGING someone to start investing at the earliest time possible is not as easy as one may think. Most people have offered so many excuses, and others have the “to see is to believe” mentality.
In the field of investment, Albert Einstein is credited in discovering the compound interest rule of 72. He is quoted as saying that compound interest is the greatest mathematical discovery of all time, and that it is the most powerful force in the universe. He said: “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Depending on the application, compound interest can work for or against an individual. If one uses it to his advantage with his investments, it will make all the difference over the long term. Long term is 30 years, 40 years or more years—not five years.
Let’s explore how it can work against an individual. Let’s assume one has a 30-year mortgage of 2,000,000, and he is paying 5-percent interest. The monthly principal and interest payment would be 10,736. That means that he will be making 360 equal monthly payments. On that first payment of 10,736, only 2,403 of it goes to pay down the principal, while 8,333 goes toward the interest. Each month, a few more pennies go to the principal, slowly bringing it down. If you add up all of the payments (360 x 10,736), one would have paid a total of 3,865,114 over the 30 years; 2,000,000 went to principal and 1,865,114 went to interest. Note that even if the balance is diminishing, one still pays the monthly due based on the original mortgage. This is similar to the add-on interest charged by the credit-card company.
If one simply takes 2,000,000 and divide it by 360 payments (assuming there is no interest), he would only pay 5,555 per month. So right away we see how damaging interest can be when it’s working against us.
It is interesting to know that the effect on the principal is minimal only at the beginning. In the first 10 years, one has paid 1,288,370 for the privilege of buying the house. Sadly, the remaining balance of the mortgage is 1,711,628. He has dutifully been paying his payments as a good borrower, and yet seems to have barely diminished his balance. The balance has gone down by less than 288,360 after 10 years (120 payments). This is a perfect example of how compounding interest can work against us.
On the other hand, if compound interest is used to our advantage, we can harness its incredible power to help propel us forward. Remember that Einstein said it was the most powerful force ever discovered.
Let’s use the same payment scheme as our mortgage example. Let’s even use the same interest rate for growth. If a person makes payments of 10,736 per month for 30 years into some interest-bearing account, earning a mere 5 percent, those payments would have grown to 8,789,540. With compound interest working against him, those payments would retire a debt of 2,000,000. With it working for him, the same would grow to 8,789,540.
Assuming that one is able to squeak out a higher rate of return, let us say 8 percent, and made the same payments for 30 years (total payment 3,864,960), one would have grown the account to 15,219,495. At 10 percent, the account would have grown to 22,323,286. In all these cases, we are looking at the same 30 years and the same cumulative amount of payments of 3,864,960. We can see proof of how compounding can help in growing wealth with great ease. The earlier one starts to invest, the lower is his required amount. Time and money can work together longer to maximize the growth of the money. When one invests later, the heavier the payment will be and time will not be enough to grow the money to its maximum.
Will you let compounding work for you or against you?
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Edmund Lao is registered financial planner of RFP Philippines. To learn more about personal financial planning, attend the 80th RFP program this December 2019.
To inquire, e-mail info@rfp.ph or text <name><e-mail> <RFP> at 0917-9689774.