Monthly Archives: March 2012

The Magic of “Compound Intrest” and the Rule of 72

One of the best things you can do as an investor  is “START EARLY“.  The younger you start your investing the longer you have for compound interest to take place.

What is Compound Interest?

Compound interest is the interest you earn on interest with the money you invest.   Now you may be saying to yourself that definition uses the word interest a lot, what exactly is interest?

I will explain using an example:

Lets say you invest $1,000 into any security (mutual fund, stock, bond, savings account, etc.) and that security earns 5% interest each year.  That means if you invest $1,000 on January 1, 2012 you will have $1,050 at the end of the year without touching your money or investing anymore.  That is $50 earned through interest.  If you were to never add money again to this account and you were to earn 5% interest each year, the following year in December of 2013 you would have, $1,102.50.  That is $52.50 made through interest for that year.  Here is where compound interest comes into play.  You made $50 of interest on your initial investment, but you also made $2.50 on the interest from year one.  That extra $2.50 is from compound interest.

If you were to never add another dime to this account, after 10 years you would have a total of $1, 620.00 (+$620 without doing anything) and in 25 years you would have almost $3,400 (+$2,400).  This does not sound like a lot over this long period, but if you were to continue to invest money every month or year, or start with a larger initial investment this number would really add up through the use of compound interest.

THE RULE OF 72

The Rule of 72 is a great way to ESTIMATE how your investment will grow over time.   If you know your investments expected rate of return (could be anywhere from 2-10% depending on the type of investment), the Rule of 72 can tell you how long it will take for you investment to double in value.  Divide the number 72 by the expected rate of return (ignoring the % sign), so if your expected rate of return was 6% you would take 72/6 = 12.  With an annual interest rate of 6% your investment should double in 12 years.  So if you made an initial payment of $20,000 dollars in a mutual fund that is expected to earn 6% annually, your $20,000 would be expected to double in 12 years and turn into $40,000.  Now, this is without ever adding any money into your investment during these 12 years.  If you were to continue to add money during this time your return would be expected to be even higher.

Here is a link to a calculator for determining Compound Interest, http://www.moneychimp.com/calculator/compound_interest_calculator.htm

Current Principal= Amount of an initial investment you would want to invest

Annual addition = amount of money you would be adding to your initial investment every year

Years to Grow = Amount of time until you would want the money

Interest Rate = Depends on what you invest in, but could be anywhere from (2-12%, I think a good average is 5%-8%)

Leave compound interest at 1 time annually and make additions at start.

Play around with the calculator and see what your investment of a certain amount can do over time.

IMPORTANT NOTE:

I will go into details on the different ways you can invest on my next post, but there are no guarantees on the amount of interest expected unless you were to invest in a Certificate of Deposit (CD) or Bond.  These have a set interest rate, that is generally very low, and they say you must hold the purchase until a specific date.  Again, I will go until detail on these types of investments in my next post.

In general, when investing in stocks , ETF’s, and Mutual Funds, the interest rate you receive will fluctuate.  There are times when you can lose money if a stock, ETF, or Mutual Fund goes down.  But, over the history of the stock market your investment will increase over time.  The Rule of 72 is a great rule of thumb to determine how your investment will perform in the long run.  Throughout the Rule of 72,  your investment will go up and down, but over the long haul your investment is expected to double following the Rule of 72.

To sum things up, one of the big keys to investing is to start early even if it is a very small amount.  Do not worry about the amount.  Start the process of investing and over time you will be amazed at the money that has been produced because of your early start.  Playing professional basketball is a great time to get an early start.  There are not many bills or taxes so it makes for extra cash to begin the investment process.

Thanks for reading Financial Hoops.

Pre-Investing Checklist

The First step before considering investing or working with a financial professional is to asses your financial picture.  You first priority should be to calculate what it cost for you to live for one month.  This includes things like, rent, food, insurance bills, house bills, having fun money, car payments, and any other bills you may have.  A great thing about playing basketball is that a lot of these “real life” expenses do not apply to us at the moment which makes it a great opportunity to begin to save money.

Once you have made this calculation and hopefully you have a positive number remanding, your next priority should be to pay off your credit card bill  (If you have one).  Having good credit plays a big part in making big life purchases (house, car, or loan) which I will talk about in a later post.  The quicker you can pay off your credit card the better.  Credit Cards have a lot of pluses, but when they are not paid off at the end of the month they can become a big big problem.  I will also discuss benefits of credit cards in another post.

The next step I would recommend would be to begin putting a little money away for an emergency fund.  They say you should have 3-6 months of income set aside for your emergency fund.  The emergency fund is a way to set money aside every month in a location (Savings Account preferably or separate bank account) where when something unexpected happens you have money already set aside waiting to be used that does not affect your normal income stream.  Otherwise, you would be forced to use your creidit card which could lead to more debt and financial troubles if it is not paid off on time.

A number of things could arise where you would want an emergency fund:

Car Repair

Lose your job and need cash while you look for a new one

Medical Payment

Dentist Visit

New Washer/Dryer

Dog/Pet gets sick

It could be anything that is totally unexpected where it is nice to have cash already set aside for this type of occasion.

The best place to store this money is in a Savings Account. Any bank should have a place where you can set this up.  You want it to be separate from your banking account because your banking is being used all the time for other daily purchases.  You want your emergency fund to be in a place where you have quick, easy access to it, but not in a place where you may be tempted to use the money from it for non-emergency purchases.  This is where you would use your Bank/Debit Card.

Once you are set in these two areas (credit card and emergency fund) you can begin investing for short-term and long-term financial goals.

Don’t worry if this leaves you with only a little cash to get started with.  Saving and Investing a little now is way better than not investing or saving at all.

Here is a simple formula for the above text:

Total Monthly Income   Monthly Living Expenses Credit Card Debt (But really a plus) Emergency Fund Money =

Amount of money you should be looking to invest for your financial goals.

Best Way to Send Money Home from Overseas

My first few years playing in Holland, The team would directly wire my money from their account to my bank account in America.  I would give them my routing number and bank information and my money would be there on payday.  This process continued for my first two years.  I began to realize that the bank was not my friend.  Their exchange rate was way less than the actual exchange rate and they were charging me a fee for the wire transfer.  I had no idea this was going on because my bank statement would just show the final total of the transfer.  I thought there had to be a better way, but I had not found it yet.

During my third year overseas, a teammate of mine explained a better way to send money home.  The company is called Custom House, http://www.customhouse.com/ , and it is operated by Western Union.  They basically act as the middle man.  Wherever you are playing, you send them the money you make in Europe and then they send that money to your bank account in America for no fee.  Here is how they make their money, They give you a little less than the actual conversion rate, but it is way better than the rate the bank gives you.

Here is a Chart to help illustrate my above comments:

As an example, I will use a transfer of 5,000 Euros to Dollars.  I will use the information I received from my bank, Bank of America,after just talking with them.  The current exchange rate at the time of this post is  1 Euro = 1.33114 US Dollars

                                                       Custom House                                  Bank of America

Amount of Euros                               5,000                                                          5,000

Fee Amount                                       $0                                                                 $16

Exchange Rate                                  1.3070                                                          1.2851

Total money Deposited               $6,535                                                      $6,409.50

                                                                               Difference:  $125.50

As you can see in this example, you would be able to save $125.50 by using Custom House to send your money home.   This would vary depending on the amount of money you send home, but if you are sending money home every month this really adds up over a 9-10 month season.  I would encourage you to call your current US Bank and ask them the following questions:

1. What is the current actual exchange rate for (Whatever your currency) to dollars?

2.  What is the banks exchange rate?

3.  Is there a wire transfer fee?

If you are interested in using Custom House and are having trouble with the process, please email me at robby.bostain@gmail.com and I will help you through the process.  The first time you use Custom House it involves some paperwork and it can be a little confusing, so please contact me if you are interested in knowing more.

Thanks and I hope this helps you save a few dollars.