Some time ago I wrote a 2 part blog entitled “What Spending Plans and Marshmallows Have in Common.” I strongly encourage you to use the filter function on our site to find that blog entry, and read both parts before reading continuing with this entry. Today’s blog is an extension of the lessons learned.
Part II of my ‘marshmallow experiment’ blog ended with the statement “Only your employer can increase your pay. But we [Success Path Consulting] can increase your purchasing power by crafting a spending plan that will allow you to have two marshmallows for the price of one.” Today I will introduce you to some important truths that will assist you in achieving the adult equivalent of 2 marshmallows. The starting point of today’s blog is a great quote from an unknown author:
“Those who understand compound interest are destined to collect it. Those who don’t understand compound interest are doomed to pay it.”
I’m guessing that even if you don’t fully understand what the quote means, you know enough that you’d like to be the person who understands compound interest, right? Then let me quickly introduce you to the Rule of 72. The Rule of 72 states that if you take the number 72 and divide it by the rate of return that you are earning on invested money, then the result will tell you how long it will take for your money to double. This is a simple enough concept that one hypothetical example should make it clear. Let’s say you have $1,000 invested earning an 8% rate of return. This is how you would apply the Rule of 72:
72 / 8 (rate of return) = 9 (years for your money to double)
So in 9 years your $1,000 becomes $2,000
Now that you understand this basic concept, we can move on to the TRULY AMAZING PART. If it takes 9 years for money to double at an 8% rate of return that means:
• $1,000 becomes $2,000 in 9 years
• $2,000 becomes $4,000 in another 9 years
• $4,000 becomes $8,000 in another 9 years
The money keeps doubling without your adding a penny, just by your having the discipline to keep it invested and not spend it. Small dollar amounts become large dollar amounts, and if left untouched, eventually become really large dollar amounts. Most people would agree that $50,000 is a large dollar amount. At 8% interest, it too doubles in 9 years, so $50,000 becomes $100,000. EXCELLENT!!! So what is the take-away lesson? Understanding the Rule of 72 and the power of compound interest transforms you into someone who is financially savvy enough to collect it.
But guess what? Compound interest can work for you or against you based on the key life choices you make. In the example above $1,000 became $2,000 in 9 years. What does $1,000 sitting in your dresser drawer become? Assuming it isn’t lost or stolen even after 99 years $1,000 will still only be $1,000. What would $1,000 at 8% interest be after 99 years – OVER A HALF MILLION DOLLARS…
So what is meant by “Those who don’t understand compound interest are doomed to pay it?” Basically you are applying the Rule of 72 in reverse when you spend $1,000 that you don’t have by using a credit card. When you buy with a credit card the compound interest goes to your credit card company’s pocket, not yours. Here is just one example:
Making minimum monthly payments on a $5,000 credit card debt at 14 percent rate would take you 22 years to pay off. You’d pay over $5,887 in interest – so $10,887 in total. Spending money that you don’t have isn’t cheap!
CONCLUSION: I’m sure you’d like to be someone who uses the Rule of 72 to your advantage. Take a moment to play around with the Rule of 72 calculator on our website. One of the core services that Success Path Consulting provides is collaborating with people like yourself to craft spending plans that help you to achieve your goals. Only you know what your dreams and aspirations are. We take the time to listen to you and identify your goals. We then craft an individually tailored spending and savings plan – A Success Path – to achieving them. Only your employer can increase your pay. But we can increase your purchasing power. The Rule of 72 is just one of the tools we teach to achieving this.