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.

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