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IWP!, flagship product is Chicago's premiere real estate Investment
magazine. Entitled Invest With Passion!, it is the tool for investors and professionals in the
Mid-West. The publication seeks to grow it's market share by providing
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person.
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continues to gain momentum and support. The education, information, and
networking opportunities for the real estate investor has been long neglected.
No More!
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It's Happening!
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THE MIRACLE OF COMPOUNDING INTEREST
By Karen
Kusamakar
A man's wealth is not in
the coins he carries in his purse, it is in the income he buildeth, the
golden stream that continually floweth into his purse and keepeth it
always bulging,
an income that continueth to come whether thou work or
travel. George S. Clason, The Richest Man in Babylon
Compounding interest is
everywhere. It is in the credit cards you use, the mortgage you pay, the
savings account you have, and the retirement account you fund, just to
name a few. Before we get into why compounding interest is so great, let's
define it. What is compounding interest? Quite simply it means whenever
interest is calculated, it is based not only on the original principal,
but also on any unpaid interest that has been added to the principal. The
more frequently interest is compounded, the faster the balance grows.
Let's take a look at a
simple example. As of the writing of this article, the average rate for a
1-year CD is 5.27%. Let's say you and your neighbor invest $10,000 into
an account with an annual interest rate of 5.27%. Your neighbor's account
is simple interest. This means he earns interest on the $10,000 he
invested. But your account is compound interest and it is compounded
monthly, which means you earn monthly interest not only on the $10,000 you
invested but also on the interest earned from the previous months. After
one year, you will have $10,539.92 in your account and your neighbor will
have $10,527.00 (see Figure 1).
Figure 1 Comparison of
1-year CD
That doesn't sound like
much of a difference now but it will once twenty years have passed. After
twenty years, you will have $28,750.62 while your neighbor will only have
$20,583.92 (see Figure 2). Your money has almost tripled while your
neighbor's money has barely doubled. And this is only $10,000. Imagine if
this was $50,000 or $100,000!
Figure 2 Comparison of
20-year CD
I know what you are
thinking, 20 years! That's too slow. I want to triple my money now. But
the secret to compounding interest is time. If you want to triple your
money fast, you will have to invest in other, more risky investments with
higher rates of return. Let's take a look at another example of
compounding interest and how time affects money. Bob and Joan are young
entrepreneurs. Both start a rehabbing company at the age of 25 and open
simplified employee pensions (SEP) that have a fixed, effective annual
rate of return of 5.27% (see Figure 3).
Joan faithfully
contributes $30,000 per year. In year 11, her husband got very sick.
Unfortunately, Joan had to use the extra $30,000 she was putting into her
SEP to pay medical bills.
Bob's wife just had a
baby and they need to move to a bigger place, so he decided not to
contribute to his SEP just yet. As time went on, the business got
successful and after year 11 Bob decided to start contributing to his SEP.
He contributes the maximum amount of $45,000 (see Figure 3).
At the end of 20 years,
Joan had contributed $300,000 to her SEP, and she had more than DOUBLED
that amount in her SEP through compounding interest.
Bob, on the other hand,
got a late start but contributed more. He contributed $450,000 to his SEP,
which is one and a half times what Joan contributed, and he still had less
money in his SEP than Joan.
If Bob keeps contributing
$45,000 per year, then he will have more in his account than Joan by year
22. However, look at the amount of out-of-pocket contributions. Bob had to
contribute in more hard-earned cash while Joan was free to use her
hard-earned cash as she wished. Joan made her money work for her. The
sooner it starts working for you, the more you will make in the long run.
Figure 3 Graph of SEP
Payments and Balances
How does compounding
interest relate to real estate investing? There are many ways this concept
pertains to real estate investing, but the most prevalent is the mortgage
you pay on your property. It is compounding interest - but it's not in
your interest. Let's assume you have a 30-year fixed rate mortgage at 7.5%
in the amount of $150,000. If you pay all of your payments on time, you
will have paid back a total of $377,575.83,or two and a half times what
you borrowed. Remember, time is the secret of compounding interest. But
time in this example favors the bank.
If you pay an extra $150
towards your principal balance for the first year and make the standard
payment for the rest of the term, you will shave 14 months off of your
loan and only end up paying back $363,780.43. That means in the beginning
you pay an extra $1,800 ($150 extra for 12 months), which will end up
saving you about $14,000.
Now rent out that
property and have the tenant pay that extra $150 for the term of the loan,
and you shave off about 9.5 years and only end up paying $293,104.47. You
just saved yourself $84,000 (see Figure 4).
Compounding interest is
the heart of the financial community. Banks make seriously good money
lending and borrowing money using the principles of compounding interest.
Figure 4 Comparison of Mortgage Payments
Be like a bank. Lend and
borrow wisely, and you will realize the miracle of compounding interest.
Note: There are other
factors involved, such as inflation and opportunity cost that have been
omitted from this article for simplicity purposes. This article was not
meant to replace professional advice. Please consult your accountant for
your financial options.
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Karen Kusumakar is the
co-founder of Preconstructionfind.com and is an expert at bringing
profitable pre construction projects to real estate investors. For a
current list of preconstruction condo & home opportunities please visit
http://www.preconstructionfind.com
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