When asked, "What do you consider mankind’s greatest invention?", Einstein replied, "Compound interest!" To this bit of wisdom I’d like to add, "If and only if it’s working FOR you." When it’s working against you, it’s a beast!
If we take the time to understand the compound interest formula, we can see how to defeat the beast and release the enormous power of compound interest for OUR good.
I promise not to get too abstract or mathematical in this discussion, so, follow along. It will be worth the effort.
This is the compound interest formula. It says:
In English, if I have $100 today, that’s "P{0}", and I want it to grow for 10, that’s "t", years at 5%, that’s little "i" then the substitution looks like:
When this formula is working AGAINST you, i.e., when you are in debt, P{0} is the amount you borrowed and P{t} is what the bank gets — from you, after time "t". To the bank, you look like an investment with a future return.
When this formula is working FOR you, P{0} is the amount you invest and P{t} is what you get after "t" years of compounding.
Look closely at this formula then think about what conventional financial wisdom encourages us to do regarding investing and borrowing money. Conventional wisdom would have us believe that we should try to be both borrowers and investors at the same time. It says, start investing early to take advantage of "t", time in the compound interest formula. However, this neglects P{0}, the amount you have to invest. If you have debts, you can’t take full advantage of P{0} because you’re paying part of what you could be investing to the bank. Remember, to the bank, you look like an investment that pays a future return.
If we are to defeat the beast, we either have to avoid it altogether, i.e., borrow ZERO dollars (in which case P(0) is ZERO) and therefore the bank gets ZERO; or if we’re already in debt, we have to drive time "t", the time we spend paying off a debt, to zero (or as short as possible). If we are successful at driving the time spent in debt to ZERO, then any number raised to the power of zero is 1, which means that at worst, we’ll owe the bank what we borrowed and nothing more (i.e., no interest). Of course, there’s no incentive for the bank to loan you money for zero time, but it doesn’t matter. They can "think" they’re loaning you money for 30 years, and you can still work to reduce time "t" to as short as possible, thereby defeating the beast.
Now, unleash the power. When you have defeated the beast, you have done so by reducing the time spent in debt, "t", to as short as possible. The average American can hack 25 years off their 30 year mortgage. When you do this, you have also increased the amount of P{0} – the money you can invest, by an enormous amount. Think of your monthly mortgage payments becoming monthly investments and you get the picture.
You now have a big chunk of money each month, P{0}, and ample time for it to compound, t, for the power of compound interest to really change your life.
__________________Greg Moore is a Certified Financial Independence Seminar Leader and teaches The Debt-FREE & Prosperous Living(tm) system for debt elimination and wealth building.