Compound interest is the eighth wonder of the world. “He who understands it, earns it… he who doesn’t… pays it.” ― Albert Einstein.
Warren Buffett has said that compound interest is an investor’s best friend and compared building wealth through interest to rolling a snowball down a hill.
A simple way to see the effect of compound interest is ‘The Rule of 72’. It’s a simple yet effective tool that allows you to grasp the compounding power of investments. By dividing 72 by the annual rate of return, you can estimate how long it will take for an investment to double in value.
For example, if an investment has an annual return of 8%, it would take approximately nine years for it to double (72 divided by 8 equals 9). This rule serves as a wake-up call for those who underestimate the exponential growth potential of their investments.
The real eye-opener here is the impact of time, and even leverage or borrowing to invest. For example, if you invest $100,000 for 30 years at 8%, then you will get approximately three compounding periods of nine years. So, $100,000 doubles to $200,000, then doubles to $400,000, and then to $800,000 over those compounding periods.
If you use this $100,000 as a deposit for a property and borrow the balance to invest in a property worth, say, $700,000, which grows at an average rate of 8% p.a. over 30 years, then you will start with $700,000, which doubles to $1.4 million, then doubles to $2.8 million, and finally to $5.6 million. Even after taking off the repayments on the loan over 30 years (which would cost $1.44 million), you would still be left with a net $4.16 million.
The critical factor here is to ensure you get quality advice before borrowing any money, but don’t overlook great leverage strategies if you have strong income and good spare cash flow and savings.
