Welcome to another post on www.therealpassiveincome.com
The topic we are discussing today can be a real game changer for your personal finances, so please, hold on tight and get ready for some shocking information!
I am sure you know who Albert Einstein is. He was once quoted saying: “Compound Interest is the eighth wonder of the world. Who understands it, earns it; who doesn’t, pays it”. I assume that we can all agree that he was one of the greatest and most influential physicists of all time. So let’s take this quote seriously for a moment. I am going to put forth some solid arguments that will hopefully help you think a little more like our good friend Albert after reading this post.
Let’s begin with a basic definition that will be added to our Glossary. What is Compound Interest? It is simply when you add the earned interest for any financial product back into your principal balance, which then earns you even more interest, because you start compounding your returns. In other words, compound interest makes your wealth & money grow faster.
Now let’s add some examples to this definition. I’ll start off by describing two different scenarios:
Initial capital invested: The first day of the year, we add some savings amounting to £1,000.
Recurrent Top-up: We make our own commitment to add a fixed amount to this pot every month. In this example it’s £150. And we imagine that this money is a recurrent Direct Debit. As an additional commitment, we increase this monthly top-up by 4% each year. So in the first year we add £1,800 to this account, the second year will be £1,872, and so on.
% of interest: This is the amount of interest we are going to get every year. (OR This is the amount of interest we will receive annually.). And this might be the real challenge. How do we ensure that we will get an average of 8% return during the next 28 years? For this I am proposing two separate strategies, always using our most TAX efficient vehicles: ISA Account and SIPP Account:
- Dividend strategy
- Index Fund Investment
Bear with me, as the next posts will disclose a lot of crucial information about both of these strategies!
Interest reinvested: This column shows the amount of actual return we will obtain every year, based on our 8% objective.
Final Balance: This is the final expected amount that we will have in our ISA or SIPP account at the end of every year.
Please find below a table that summarizes all of the above explanations in this first scenario:
I know there are a lot of numbers on this table, so let’s focus on a few conclusions:
- The total amount invested over the years amounts to £95,339.32 + £1,000 as initial capital invested.
- This scenario shows that if we are able to obtain a 8% return per year, we will have generated over the years an amount of £214,231.06.
- If we are able to follow all of these assumptions through the years, we could have a lump sum of £310,570.37, which is a lot of money in my opinion!
I don’t want to make things more complicated so the only difference between this scenario and the previous one, is that in here we are going to cash out the 8% return every year. Let’s take a look at the picture below to see the impact of this change:
As shown on the chart above, we get as a final balance our capital invested over the years: £95,339.32 + £1,000 (initial balance). During this time, we have cashed out the return obtained at the end of each year. Obviously, we have had some cash available to use, but there is a huge disadvantage in this second scenario: as we are not compounding the 8% interest obtained every year, we have made “only” £96,225.78 over the same amount of time.
This means we have a final lump sum amounting to £96,225.78 + £96,339.32 = £192,565.09.
If we compare both scenarios, we can clearly appreciate the magic of the one with Compound Interest, can’t we?
If our choice is to compound our yearly return, we get a final lump sum amounting to £310,570.37 versus a final amount in Scenario 2 (withdraw return every year) of £192,565.09.
This chart shows us a variance between both scenarios amounting to £310,570.37 – £192,565.09 = £118,005.28.
As with everything in finance, there is not a single correct answer, and over the years we all might need some extra cash at some point. However, if we are disciplined enough to keep going with our plan, we can put our money to work for us! We will be able to enjoy a good retirement, where hopefully money won’t be a problem, and more importantly, WE won’t be a financial burden for our grown-up children.
Thanks a lot for reading, and please reach out to me if you have any questions, as understanding this post can be a real game changer for our future financial situation!
Data policy – All information should be used for indicative purposes only. You should independently check data before making any investment decision. TheRealPassiveIncome.com cannot guarantee that the data is accurate or complete, and accepts no responsibility for how it may be used.
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