Compound interest. Albert Einstein called it the 8th wonder of the world. Einstein said, “He who understands it, earns it… he who doesn’t, pays it.” Seriously though, calling compound interest the 8th wonder of the world seems a tad bit extreme, right?
Perhaps, but the essence of financial planning is making compound interest work for you, not against you.
Let’s first start with the basics. What is compound interest and how does it differ from simple interest?
Simple interest is interest earned or charged on an original principal balance.
As an example, if you lent $1,000 at 4% simple interest over 5 years, you would earn:
$1,000 * 4% * 5 = $200 in interest
Compound interest is interest earned or charged on the original principal plus accumulated interest of previous periods – otherwise known as ‘interest on interest’.
Using the same example, if you lent $1,000 at 4% compounded annually over 5 years, you would earn:
Year 1: $1,000 * 4% = $40
Year 2: $1,040 * 4% = $41.60
Year 3: $1,081.60 * 4% = $43.26
Year 4: $1,124.86 * 4% = $44.99
Year 5: $1,169.85 * 4% = $46.79
Total interest = $216.65
Simply put, in the instance where money is lent, compound interest allows the lender to earn money on money s/he did not initially invest. So, with time, compound interest grows exponentially faster than simple interest. Pretty sweet!
The effects are most pronounced with a larger amount lent. Take the more real-world example of investing $100,000 at 6% over 20 years:
Simple interest = $120,000
Compound interest = $220,714
OK, great, but how does compound interest enter the financial planning discussion?
There are 3 reasons why families do not achieve the goals they envision:
1) They live too long
2) They die too soon
3) They become sick or disabled
Living too long
Simply put, if you do not have a strategic investment plan compounding effectively over time, there is a good chance you’ll outlive your retirement savings. By the way, what I mean by compound effectively is steady growth over a long period of time.
You know that ridiculous Questrade commercial where the slimy advisor says, “it’s a long-term game”? Although the language and everything surrounding his message is terrible, the idea is not wrong.
A well-balanced portfolio that compounds effectively over time is crucial during the wealth accumulation (i.e. ‘working years’) phase of your life. This is compound interest working for you!
Take a look at the return pattern below, which shows two portfolios for which the average rate of return over the 10-year period is 7%.
If both return patterns have an average rate of return of 7%, shouldn’t the total amount of money in year 10 be the same? At first blush, you may think so. But, see below:
The bottom line? A well-balanced portfolio, which delivers consistent returns over time like Portfolio 1 above, conserves capital in a downmarket. This means there is more capital that can compound when the market bounces back.
In addition, a well-balanced portfolio ensures you don’t have a heart attack every other day from market fluctuations.
Dying too soon
If you died today, financially, what would that look like for your family? Would they be able to maintain the lifestyle they are used to living?
If not, where would they get money from?
They would likely have to sell the house, pull from retirement savings or take on debt.
Not only are assets being taken away that accumulate positive compound interest, but debt is being added that accumulates negative compound interest.
Although compound interest can be your greatest ally, it can also be your worst enemy. When debt continuously accumulates it can feel like you’re sinking into quicksand. Thinking about retirement is not even a possibility.
If the goal is to minimize compound interest working against you how do you prevent this from happening for your family if you die too soon?
The most affordable vehicle to ensure that your family will be OK if you die too soon is life insurance. For this, you should work with an advisor to determine what your need is and to come up with a budget you are comfortable with. Even if you can’t fully satisfy your need, some coverage is better than no coverage.
Getting Sick / Disabled
You put a financial plan in place that paves the way for you to retire at 65. You stick to the plan and are saving money accordingly, as you can’t wait to work on your golf game year-round as a snowbird.
Life tends to take unexpected turns…
What if you become disabled or critically ill and cannot work? Your work benefits will cover you for a short period of time, but is there a plan in place to ensure your income earning ability is protected?
If not, it’s hard to believe that you’ll be swinging the sticks 365 days of the year when you hit 65.
If there is no plan in place, you’ll likely start withdrawing money from your retirement savings.
I wrote an article a while back that shows the cost of withdrawing money from your retirement savings.
The example shows that if you start saving $450/month in your TFSA at age 25 (at a 5% rate of return) you would have $686,000 at age 65.
However, if at age 47 you withdraw $200,000 from your TFSA due to disability/illness, assuming you continue to save $450/month (which is unlikely), you’d have only $195,000 at age 65.
Withdrawing $200,000 at 47 cost you $491,000 at age 65, all because of compound interest.
A far less expensive option is to have a disability and critical illness insurance plan in place to protect your ability to earn income and to protect your retirement savings.
To keep your goals on track you need a financial plan that makes compound interest work for you, not against you; a plan that covers both the offence (investments) and the defence (insurance).
Having a sound investment strategy that builds your wealth over time is only half the battle. A portfolio of insurance ensures your offence stays on track, giving you peace of mind.
For additional questions reach out to me at firstname.lastname@example.org.
Sunrises in Bagan overlooking the Pagodas and hot air balloons is truly spectacular – something you will never see anywhere else. This photo was shot in February of 2016, Myanmar still felt as though it wasn’t used to tourism. We saw some amazing places in Myanmar but Bagan was truly special. We spent one day renting mopeds hopping from Pagoda to Pagoda. With over 2000 Buddhist monuments spanning the region we barely scratched the surface.