The Trick that Seems Impossible, or the Magic of Compound Interest
"Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn't pays it." ~Albert Einstein
Hello, Talking About Money Community. I’m sending positive vibes your way. 🙏🏼
Today I want to start with a question: Do you discuss the magic of compound interest with your clients? Come on, you can be honest with me – yes or no? If your answer is yes, then good for you (and your clients)! If your answer is no, then read on:
I am going to take a guess that say that many, if not most, of you center your financial counseling and education around cash management – am I right? You love budgets and you cannot lie…
I am not knocking on budgets. I like to discuss them myself, though I prefer the less-loaded term “spending plan” (cuz budget = money diet, and I covet what I cannot have). Budgets can give you and your client a lot to chew on (no diet pun intended) since you can dive into topics such as needs vs. wants, spending leaks, and smart shopping. An artfully crafted budget can uncover extra dollars in your client’s monthly cash flow that can be diverted towards creating an emergency fund or saving for a financial goal.
But what happens after the budget has been developed and executed? Then what do you talk about? You might discuss saving and choosing the appropriate bank account, whether that be a savings or money market account, or even a certificate of deposit. This can be helpful, as having an established banking relationship gives your client a firm foundation on which to build their financial life. But the interest rates paid out by savings vehicles will only get your client so far.
This then leads you to the concept of investing. You might shy away from discussing investing because you do not have the appropriate license, and you do not want your words of wisdom being misconstrued as giving investment advice. That is a prudent course of action and staying within your boundaries, but where does that leave your client when they are trying to think about how they are going to fund their future in general, and their retirement in particular?
I believe that as financial counselors, educators, and coaches, part of our marching orders should be to explain financial concepts so that they are easily understood and acted upon. And once that our clients get to a place where they need and/or want an financial advisor, then we should have a virtual rolodex ready to refer them to a fee-only, fiduciary financial advisors that can provide them with the investment advice that they want and need.
Now back to compound interest: What is it, why is it important to understand, and how can your clients put it into action in their own lives?
What is compound interest?
Simply put, compound interest is the interest you earn on interest. If you earn interest on what you have deposited into an account, and you leave that interest in your account for a specified period of time, that interest will then earn its own interest, and so on and so forth through the future.
In this example from Investor.gov, if you have $100 and it earns 5% interest each year, you'll have $105 at the end of the first year. At the end of the second year, you'll have $110.25. Not only did you earn $5 on the initial $100 deposit, you also earned $0.25 on the $5 in interest. While 25 cents may not sound like much at first, it adds up over time.
Why is compound interest important?
According to Smart Asset, when it comes to investing, compound interest allows funds to grow at a faster rate than they would in an account with a simple interest rate (Principal Balance x Interest Rate). Compound interest comes into play when you’re calculating the Annual Percentage Yield (APY) -- that’s the annual rate of return on money that you have invested.
It’s also important to understand compound interest when it comes to borrowing, such as student loans, personal loans, or mortgages. With these types of loans, the longer the term, the more your client will pay in interest payments over time. In brief, the shorter the term, the less interest paid; the longer the term, the more interest paid.
Why is it important for your clients to understand this concept? While some may come to believe that people become rich overnight through savvy investing, for the vast majority of people, finance is a long game. While compound interest does indeed cause money to appear magically, it takes years – maybe even decades – for this trick to become reality.
And this is difficult because most of your clients are living in the here-and-now. They are buying their groceries today, then filling their gas tank next week, and working hard to make it through each month. Their financial stability and security is not going to improve magically overnight, yet it is days and weeks that they are focused on, rather than years and decades.
How can you put compound interest into action?
Now that we know what compound interest is and why it is important, how can you help your clients put it into action for themselves, especially when they are focused on the here-and-now? Here are a few options:
Start today: According to Clever Girl Finance, “the most effective way to boost your compound interest returns is to start investing as soon as possible. With more time on your side, you stand to gain more from compound interest. Make a plan to save early and save often.” According to a well-known Chinese proverb, “The best time to plant a tree was 20 years ago. The second best time is now.”
Automate, automate, automate: Automating your saving and investing gives you the ease and satisfaction of set-it-and-forget-it. By utilizing tools like direct deposit in your paycheck or auto-transfer in your checking account, you can make one decision of how much you want to save or invest on a weekly or monthly basis, set it up, and then watch the principle start to grow.
Consider the interest rate: This is key to helping your clients grow their savings and investments over time. While traditional bank accounts bring with them the comfort of FDIC protection up to $250,000, nowadays even the best savings accounts tend to offer interest rates of less than 1%.
Using the Rule of 72, $1,000 invested at a 1% interest rate will double to $2,000 in 72 years! Alternately, $1,000 invested at a rate of 7% will double to $2,000 in a little more than 10 years. To earn a 7% rate of return, a regular ol’ savings account is not going to cut it. If your client wants to earn a higher rate of return, then they need to consider investing in the stock market. This means seeking out professional advice from a someone like a fee-only, fiduciary financial advisor.
Do you have questions about making compound interest work for your clients? Use this handy compound interest calculator from Investor.gov!
