Understand the Compounding Effect of Money

The compounding effect of money is extremely important when making any financial decision. The compounding effect of money is often overlooked or underestimated by people when making decisions. When applied to all of your financial decisions, this effect is the KEY to long-term success! To illustrate the compounding effect of money, let me use some financial examples:

Suppose you had invested $1,000 today in a 5% savings account. In one year, that account would be worth $1,050 [$1,000 + ($1,000 x 5%)], yielding a $50 gain. However, in year two, that same initial investment would be worth $1,102.50 [$1,000 + ($1,000 x 5%) + ($1,050 x 5%)], yielding a $52.50 gain. And in year three, the same $1,000 would be worth $1,157.63, yielding a $55.13 gain. By year ten, the initial $1,000 investment would be worth $1,629 and by year 25 it would be worth $3,386.

From looking at this example, you can see that investing $1,000 today is much more valuable than investing $1,000 even a couple of years from now. To accumulate wealth, you MUST use the time value of money and the compounding effect of money to your advantage. Click here to see how long it will take to save a million dollars.

This second example shows how the compounding effect can work against you:

Suppose you borrowed $20,000 to purchase a car and your auto loan was at a 10% interest rate (for 5 years). Your monthly payments would be $424.94. Because the $20,000 loan continues to compound over the life of the loan, you actually pay $25,496.45 over the five-year period, meaning that you’ve in essence paid $5,496.45 because you spent the money before you had it. In fact, in your initial payments, the interest alone will account for almost 40% of your monthly payments. In this case, the bank or lender that gave you the loan uses the time value of money to their advantage.

Now look at this scenario, where instead of making the $424.94 car payment, you invest that payment at the same rate as what your car loan was (granted it’s a little high for a savings rate, but not unreasonable for other investments). Now, instead of paying the bank, you are actually earning interest and compounding the benefit yourself. After one year you will have saved $5,340 and have earned $240 in interest. After two years, you will have saved $11,239 and have earned $1,039 in interest. By the third year, your investments will be worth almost $18,000 and you will have earned $2,457 in interest. By month 40, you will have enough money to purchase a $20,000 car in cash!

So let’s weigh the differences between the two scenarios above. In the first case you paid the bank $5,496 to borrow the money and in the second case you earned $2,457 and could buy the car in cash after just 40 months (just over 3 years)! The opportunity cost of the first alternative versus the second alternative results in a net difference of $7,953 (a $2,457 gain versus a $5,496 loss). That means that by making a simple deferral decision (buying the car in 3 years versus today), you can get ahead by almost $8,000!

The next rule is to take appropriate financial risks:

Understand the Time Value of Money

The most basic law in finance! The time value of money states that a dollar today is worth more than a dollar at some time in the future. Okay, it’s not that simple to understand at first glance so let me delve into this advice a little with some financial examples:

If I invest $1,000 in a 5% savings account today, it will be worth $1,050 in one year. Therefore, if I can have $1,000 today or choose to have $1,000 one year from now, it is always better to have the money now. By saving and investing today, you make the time value of money work for you.

Let’s look at the reverse of this, to see how the time value of money can work against you. Suppose instead of receiving $1,000 that you spent $1,000 by purchasing merchandise on your credit card. Remember that a dollar today is worth more than a dollar tomorrow, so in this case, you will have lost money because you will need to pay off your credit card account with money from the future (which is worth less than money today). In addition to having to pay with future money, you will also have to pay interest expense. So, in this case, if you paid off the credit card in one year (assuming 15% interest), you’d have to pay $1,150.

You should think about the time value of money before making any decisions. Another, maybe even more important concept related to the time value of money is the compounding effect of money.

The next rule is to understand the compounding effect of money:

Understand Opportunity Costs

Opportunity cost is defined as the cost of pursuing one alternative versus another. For example, if you were going to spend $500 on a new bike, the opportunity cost would be that you would not be able to buy anything else with or invest that $500. For the purposes of financial planning, you should look at the cost versus the benefit of each decision you make. In this case, you could spend $500 on the bike or you could invest the same $500 in a savings account. In five years, the bike will be worth $25 and the $500 investment will be worth $650 (including interest). The opportunity cost of buying a bike is the long-term benefit that you will receive if you did not buy the bike and invested it. Technically, the opportunity cost is not limited to the cost of investing the money, but also includes any other opportunity you could spend the money on (investing, buying something else, saving the money, etc). By carefully evaluating your alternatives and by weighing the opportunity cost of each decision, you can vastly increase your long-term wealth.

The next rule is to understand the time value of money: