The Effect of Compounding

by Dave Miller

Albert Einstein called compound interest the eighth wonder of the world.

Compounding works for positive and negative. If you are dumping your savings, or future earnings, into the latest high-risk scheme every time a new one comes along you are compounding negative results. But if your build good habits they stick with you and they compound (explain)

What Einstein was referring too was putting money on interest and the interest being put back into the account. As the interest is added to the original amount you then receive interest on the initial investment plus the added interest. As years go by the amount collecting interest grows and grows. All the while you are not spending your money because you would rather have more money later.

Money put into a saving account that only a start when looking at compounding. If you invest in real estate with a mortgage and use the cashflow to pay down the loan you get the same effect. Let’s say after you pay the required monthly payments and then use the excess to pay off additional principle you dramatically decrease the length of the loan.

Example: You buy the house for $133,000 and get a loan for $100,000. You have expenses of $200 month for taxes and insurance. Your payment on the 30 year loan is $665 leaving you with $335 cash flow on your monthly rent of $1200.

  • The short-term thinker will spend the money something frivolous the week gets his $335. So he pays off the loan in 30 years. He quadruples his investment of $33,000.
  • The mid-term thinker uses the $335 to pay down his mortgage and quadruples his invest in 13 years
  • The long-term thinker puts an additional $150 towards the mortgage knowing he will never miss it. He pays off the loan in 10 years, thus quadrupling his investment.

Are you a present-oriented or a future-oriented thinker? A future-oriented thinker can abstain from something now for a greater good later. While a present-oriented wants what feels good, now. They think past the present.

Habits as well as finances are affected by your length of thinking.

Building habits takes effort. You must forego something; time, energy, money, etc, to build a habit. This forgoing is the key. A little effort now grows into something big over time.

I’m not talking about some flashy hyped-up new you. Quite the contrary. I’m referring to little habits that add up.

  • Getting up a half hour earlier
  • Spending quality time with your family
  • Taking a brisk walk regularly
  • Smile more
  • Make a to do list

These small efforts over time will bring outstanding results.

As a sales man once said, “As an added bonus we will throw in a few extras.” Here’s your bonus; not only do these habits give you long-term benefits. The things I mentioned above that grow over time, also give me instant results.

Invest in yourself. It’s the best investment you can make. Long term investing beats short-term through the compounding effect. So the longest term invest you can make in your lifetime is in yourself. If you improve yourself it continues to grow. A seemingly minuscule habit will grow exponentially in your lifetime.

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Published in: on June 14, 2011 at 8:50 am  Comments (1)  

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