THE MIRACLE OF COMPOUNDING INTEREST

Described by Albert Einstein as the "Eighth Wonder of the World," compounding interest is driven by time - the essential ingredient to successful investing. Too many times we have heard people say "I have plenty of time to invest. I'll start in a few years." Words most people regret once they see the result of their procrastination.

Compounding interest is defined as interest calculated not only on the initial principal but also the accumulated interest of prior periods. The simple calculation is as follows:

A = P(1 + r)n

Where:

• P = the principal (the initial amount you deposit)
• r = the annual rate of return (percentage)
• n = the number of years the amount is deposited for
• A = the amount of money accumulated after "n" years, including interest

This calculation becomes more complicated when additional contributions are made or if compounding occurs on a more frequent basis (monthly, quarterly, etc.).

The following example will best explemplify the importance of compounding interest:

INVEST EARLY VS. LATER

Facts:

• Earl, the early investor, invests $10,000 at age 30 and NEVER invests another penny.
• Larry, the later investor, waits until age 40, invests the same $10,000 as Earl and subsequently invests an additional $1,000 per year for the next 10 years for a total investment of $20,000.
• Each investor has a 9% annualized return

Results:

Even though Earl's principal investment is $10,000 less than Larry's, at age 60, Earl ends up with a total investment of $132,000, which is 41% greater than Larry's $93,000. Essentially, the day Larry decides to invest (age 40), Earl's investment has already increased to $23,674. And even after Larry invests an additional $10,000 over the subsequent 10 years (age 41 to 50), Earl's investment balance at age 50 is $56,044, which is still greater when compared to Larry's $39,550.

Analysis:

The significance of compounding interest goes beyond the additional $16,494 Earl has accumulated at age 51. More importantly, by investing earlier, Earl has created a larger asset base than Larry (even though he has invested $10,000 less than Larry). With a larger asset base Earl will experience greater annual returns (in dollars) than Larry.

For example, in year 22 (age 52), Earl has a beginning balance of $66,586 and ends with $72,579 for a return of $5,993. Meanwhile, Larry begins with $46,990, ends the year with $51,219 for a return of only $4,229. Even though both earn a 9% return on their investment, Earl has a greater return in terms of dollars (the difference being $1,764).

This return difference will remain for the life of the investment period and with each year the difference will grow because Earl will begin with a greater asset base. This greater asset base was created for one simple reason - investing earlier and taking advantage of the miracle of compounding interest.