Luc Delorme | Money Talk: Here’s … the power of compound interest | Business


GREATER BARRINGTON – To my amazement, there are still many financial concepts that are not part of our basic education. The result is that many smart people misunderstand the immense power of compound interest. Many people do not understand how interest rates work and cannot understand how the composition multiplies over time.

Let’s start with the basics of interest rates. If you buy a couch for $ 1,000 on a credit card with a 20% interest rate and pay it off a year later, you will have paid $ 1,200. It’s $ 1,000 for the couch and $ 200 for interest, or 20% of $ 1,000.

However, if you wait two years to pay it off, you’ll pay $ 1,440. This includes the interest payment of $ 200 in the first year and compound interest of $ 240 in the second year. The second year interest is charged on both the initial cost and the interest accrued in the first year. You can see how the compounding starts to turn small interest payments into bigger ones, even in a short period of time. This is why you want to avoid high interest rates when you borrow and pay off your debts as soon as possible.

This is also why you want to start investing as young as possible. Compounding gets really powerful over decades, or a lifetime. This is how even modest savers can become millionaires. A saver who invests $ 5,000 per year and earns 7% per year will have just under $ 1 million in 40 years, thanks to compound interest. Interest earned in the first year is only $ 350, or 7% of $ 5,000. But the interest earned in the fortieth year would amount to nearly $ 65,000 thanks to the much larger account value in year 39.

People massively underestimate the extent of compound growth. Here is an example of the impact this can have. A typical domino is about 2 inches tall. If you double it you will have a 4 inch domino, double it again and you will have 8 inch. How many times do you have to pass this domino to reach the height of the Empire State Building which is 1,454 feet?

The answer is surprising. If you doubled the size of this domino just 14 times, it would reach 2,700 feet enough to topple New York’s tallest structure with ease. The numbers are staggering.

When it comes to investing, you can expect your money to double about once every 10 years with an assumed rate of return of 7%. In 40 years, it would almost double four times, with $ 1 becoming about $ 15.

So, is a 7% rate of return on your money realistic? Can someone who saves just $ 5,000 a year really expect to be a millionaire? Since 1926, the average return on the US stock market, including dividends (S&P 500), has been just over 10% per year. There is certainly no guarantee that the future will reproduce the past, but 7% per year over the long term is not excluded. If you put just $ 1 in the S&P 500 in 1926, it would be worth $ 8,307 at the end of last month.

Famous investor Warren Buffett is a prime example of the power of capitalization. He said, “My wealth came from a combination of living in America, a few lucky genes, and compound interests.” Buffett is said to be worth around $ 90 billion, which would rank him as the third richest person on the planet. But Buffett, 88, has amassed over 90% of his fortune since he was 60!

Buffett is said to have started saving and investing at the age of 11, giving him over 75 years of funding. Buffett obviously made wise decisions from a young age and had a formidable temperament for investment and luck, to which he credits much of his success. Time, however, was a critical part of his success.

The power of composition is not an intuitive concept for most people. We must not only understand this concept, but it must be basic education for all. The earlier we learn it, the more beneficial it can be.

Luke Delorme is Director of Financial Planning at American Investment Services in Great Barrington. He can be contacted at [email protected] Past performance is no guarantee of future results. This information should not be construed as investment advice or a solicitation to purchase securities. A professional advisor should be considered before implementing the options presented.


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