Updated: Oct 16, 2019
According to Wikipedia, Compound Interest is defined as "the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest." Albert Einstein purportedly said that "Compound interest is the eighth wonder of the world", and Benjamin Franklin said "Money makes money. And the money that money makes, makes money”.
So what exactly is compound interest and why is it so important a factor in wealth building?
Let's assume that a 30 year old begins to save and puts $500 every month into an account earning 5% interest and never takes any of the money out. The graph below shows you what that uninterrupted compound interest will do to that account. Notice how the volume of interest earned grows at an ever increasing rate. This is the "magic" of compound interest. After one year, you have saved $6,000 and earned $139.43 of interest. In year 30, the interest earned is over $20,000!! This is because you are earning interest on all of the prior years' deposits and interest on all of the interest earned in all of the prior years - just like Benjamin Franklin observed.
If we were to continue this process out for 100 years, the interest earned in the 100th year would be over $850,000!!! That is more than the total amount that was saved over that time period ($600,000).
While we all would love to be earning the interest on the right side of the graph, we cannot get there without starting on the left and allowing compound interest to do its thing.
This exponential curve is also referred to as the "wealth curve". If we were able to take every penny that we ever earned and saved it, the curve would represent our "maximum potential" at any point in time. But as they say, "life gets in the way". If the above example of saving $500 per month was really our "car buying account", every time we took money out of the account to buy a car (for cash), we "fall off" the wealth curve.
This graph represents saving $500 per month and every 5 years buying a car for $25,000 in cash. Notice how at the end of 30 years, instead of having over $400,000, we would only have a little over $100,000. And yet we only spent $150,000 on cars (6 X $25,000). So by "falling off" the wealth curve and interrupting compound interest, we lost over $150,000 in interest!
So the key point here is to start saving early and let compounding work for you. When you implement the family banking strategy using a correctly constructed whole life policy, you are able to stay "on" the wealth curve because the cash value in your policy continues to grow at the same rate even if you borrow against it to make purchases.
Staying "on" the wealth curve is the key to financial freedom, not chasing higher returns in higher risk investment options. As Warren Buffet said, "Time is your friend, impulse is your enemy. Take advantage of compound interest and don’t be captivated by the siren song of the market."
Contact me for more information on implementing the family banking strategy in your personal economy.