October 2, 2019
The investment world is full of jargon and complicated sounding terms. While they may sound like words from a foreign language, taking the time to learn and understand them can lead to great rewards.
Today we talk about a couple of terms that are exactly that: Compound Interest and Reinvested Returns.
Reinvested Returns – earnings, like interest, are put back into the investment rather than paying them out to the investor. This is done to earn even more returns.
Compound Interest – this is basically earning interest from your interest. Returns are continually reinvested which makes the total investment grow with each iteration.
Unless you’re living in an isolated shack in the mountains, you can see interest everywhere. It’s such a common thing in our modern world.
There’s interest when you borrow money for small things like using your credit card or personal loans. It’s also there when you buy bigger things like a new car or when you take out a mortgage for when you buy your first home.
When you deposit money in the bank in some form, the bank is technically borrowing money from you, so you receive some interest from that.
A regular checking account has a small amount of interest. CDs or Certificate of Deposits are a type of high interest savings account that offer fixed interest rates.
Interest, especially compound interest, is a powerful tool. This is why banks spend so much time calculating and tweaking interest rates down to fractions of percentages.
Understanding how compound interest works can be the difference between wallowing in debt and earning financial freedom.
There’s a whole community called the FIRE (Financial Independence Retire Early) movement that use their knowledge of compounding interest to become financially free.
But first let’s see what the difference is between simple interest and compounding interest.
These are two similar yet massively different types of interest. They both occur over time but the change is one is linear and the other is exponential.
This is simply having a principal amount and paying out interest based on that in regular intervals.
Let’s say you have $10,000 in an investment that pays 10% in simple interest annually. This means you get an additional $1,000 per year. Simple, right?
“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” — Albert Einstein
With compound interest, each interest payout is reinvested. Interest is then also earned on that in the next interval.
This is where things get interesting. When you keep reinvesting your returns, the pot of money that’s earning interest keeps growing.
So let’s say we take that same $10,000 and put it in an investment which has 10% in compound interest annually. This means in the first year the investment grows by $1,000 to $11,000. The next year it grows by $1,100 to $12,100, and so on.
This type of interest has the potential to grow to huge amounts – especially over the long term.
To see the potential of what reinvesting returns and compound interest can do, let’s see some numbers projected over a period of time.
While that additional $5,937.42 from compound interest doesn’t seem like a lot, it’s 29% more than using simple interest.
Not bad. But let’s push it further. How about a time horizon of 40 years? This is still feasible since the average working career is exactly that. So let’s give the money the same 4 decades as a working career.
A whopping $400,000 difference between simple and compound interest!
Now let’s compare growth:
That’s more than 9 times more money! If this doesn’t inspire you to start investing at a young age, I don’t know what will!
If you just socked away your money you’d still only have the same $10,000 but with a much lower buying power. That’s inflation for you. You miss the boat if you don’t invest.
Although the percentage return here is simplified to 10% and does not make adjustments for market downturns, inflation, and other factors, this effectively illustrates the power of reinvesting returns and compound interest.
Here are some ways to get into that sweet compound interest action.
You can start a business and then reinvest your profits back into the business. Although calculating the actual returns from reinvestment is more complicated, it works in the same way.
Real Estate and REITs
When you do traditional real estate, it may prove more challenging to reinvest your returns continually since buying whole properties requires large chunks of capital. But you can buy into Real Estate Investment Trusts (REITs) for ‘shares’ of properties. DiversyFund’s Growth REIT is an example of this.
It takes money to make money and the more you have, the more you can earn.
The great thing about this is, some of the investment vehicles mentioned earlier can actually earn you money without you having to work for it. This is called passive income.
If you invest in mutual funds, index funds, or REITs and set them to reinvest earnings, you don’t really have to do anything except watch. You can earn compound interest without really doing much work.
Earning compound interest by reinvesting returns is a great way to have your money make more money – which is the secret to building long-lasting, even multi-generational, wealth.