So how can someone who is an average wage earner grow their money like a rich person? The answer lies in... math!
We've all heard stories about how some little, old lady with no family and worked as a librarian all her life passes away and leaves behind a $2,000,000 estate! People far and wide wonder how could this woman who earned at most $35k in a year could accumulate that much money! The reason is the power of compound interest!
Compounding Interest
Interest is the money you earn from financial institutions for allowing them to use your money to loan out to their clients. Banks can pay you this interest because they charge higher interest rates to their clients. So what is "compounding interest"? Compounding interest is how your money grows each year. Look at the following example.
Let's say you deposit $10,000 into a savings account that will pay you 2% interest each year. This is a very realistic rate that you would earn from a savings account from an online banking institution. What's not realistic is we are not going to be adding anymore deposits to this account during the year. At the end of the first year, the bank adds your 2% in interest to your account. Again, they will usually do this monthly or quarterly, but we are going to keep it simply with yearly interest. So they add $200 to your account. Now you have $10,200 in your account. At the end of the second year, they add another 2% in interest, not just on the $10,000, but on the $10,200 that you now have. So at the end of the 2nd year, they add $204 to your account. Now you have $10,404 in your account. End of the 3rd year, they add another $208.08 giving you $10,612.08. That is compounding interest. This might not seem like great growth, but that's the process. The better return you can get from your money, the faster it will grow.
The Rule of 72
We've looked at compounding interest. There is a simple way of calculating what your money will do over time. You look at your rate of return and see how many times it will go into 72. The total will be how many years it will take you to double your money. So in our previous example of 2% interest, we would double our money every 26 years. Not a great rate of return. Let's say we take that same $10,000 and invest in the stock market that will return on average 7%. We should double our money in 10 years. Everything rounded to the nearest whole dollar.
Starting money - $10,000
Rate of Return 7%
Year 1 - $10,700
Year 2 - $11,449
Year 3 - $12,250
Year 4 - $13,108
Year 5 - $14,026
Year 6 - $15,007
Year 7 - $16,058
Year 8 - $17,182
Year 9 - $18,385
Year 10 - $19,671
So you can see that after 10 years, even with you doing absolutely NOTHING, you have doubled your money! This is without you adding ANY more money into your account! This is the power of compounding interest!
Now let's look at an that same scenario except that we will continue to add $100/month to that account since we should constantly keep saving.
Starting Money - $10,000 adding $100/month
Rate of Return 7%
Year 1 - $11,900
Year 2 -$13,933
Year 3 - $16,108
Year 4 - $18,436
Year 5 - $20,926
Year 6 - $23,591
Year 7 - $26,443
Year 8 - $29,494
Year 9 - $32,758
Year 10 - $36,251
So just by adding another $100/month into our account, we have increased our total savings by another $16,500. This is something that you can achieve! Now let's imagine you have followed the T.A.'s advice and have become a super saver $500/month. What would those numbers look like?
Starting Money - $10,000 adding $500/month
Rate of Return 7%
Year 1 - $16,700
Year 2 - $23,869
Year 3 - $31,540
Year 4 - $39,748
Year 5 - $48,530
Year 6 - $57,927
Year 7 - $67,982
Year 8 - $78,741
Year 9 - $90,253
Year 10 - $102,570
This is where you can really start to see why we need to work on that savings rate and how we can start to build true wealth. So as you continue to build your portfolio, you can start to project the money you will have as you go through the years.
Keep stackin!
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