You have most likely heard the expression Time is money. But do you know what it means?
Surprisingly, many people believe it to mean that if you spend many years working for a company, you'll end up with loads of money. But how many people do you know that this happened to?
Going to work will generally help you make enough money to earn a living while you're working. While this is what most of us do, that's not what Time is money means. After all, it does not say work is money. It says time is money.
I can really think of only one thing whoever said it first could have had in mind: Compound interest.
Understanding how compound interest works, and taking advantage of it, is the main difference between the rich and the poor.
Contrary to common belief, striking it rich is not a matter of luck. I mean, sure, someone occasionally wins the lottery or finds uranium on his land. But those are exceptions.
Have you noticed that children of the rich tend to be rich, while the children of the poor tend to be poor? It's not because the children of the rich inherit their parents' fortune. It's because the rich parents understand how money works and teach that understanding to their children.
Most of the poor don't understand it, so they can't teach it to their children (some do understand it, but for whatever reasons do not apply it, but, again, those are exceptions).
Strangely enough, American schools do not teach the "secret." Perhaps they are afraid that the teachers would get rich and quit teaching. Or whatever.
Ironically, as I grew up in a Communist country, we were taught these things somewhere around the third grade, but because of the Communist system it did us no good. Oh, well.
OK, now, let's get to it. We shall study the magic of the compound interest next.
Suppose you are 20 years old and have $1,000. Let's also suppose you are different from most 20-year olds, and decide not to blow that money, but put it in a bank savings account with a 3% APR, and will keep it there until you retire.
What happens to it? Using the Rule of 72, we determine that your money will double every 72 / 3 = 24 years. So, this is what you have at different ages:
Age 20: $1,000
Age 44: $2,000
Age 68: $4,000
Might as well blow it now because 48 years from now $4,000 will buy less than $1,000 buys today.
But suppose you are the thrifty type and decide not to keep the money in the bank but put it into some government securities which earn a 6% APR. That's twice the rate the bank was paying.
So, how much money will you have at age 68? Twice the interest, twice the money, right? Wrong!
Using the Rule of 72 we determine your money will double every 72 / 6 = 12 years. Here's how it will grow:
Age 20: $1,000
Age 32: $2,000
Age 44: $4,000
Age 56: $8,000
Age 68: $16,000
Ah, not twice as much money, four times as much with double the rate. Guess what, might as well blow it. The inflation rate during that time period will average 6% a year. So, $16,000 after 48 years will buy the same as $1,000 now!
But then you notice that many mutual funds average 12% annual earning over a long period of time. And 48 years is a long period of time.
12% is twice the rate of 6%, so you figure your money will grow to four times the 6% rate, right? Well, let's see.
At 12%, your money will double every 72 / 12 = 6 years (good ole' Rule of 72 again):
Age 20: $1,000
Age 26: $2,000
Age 32: $4,000
Age 38: $8,000
Age 44: $16,000
Age 50: $32,000
Age 56: $64,000
Age 62: $128,000
Age 68: $256,000
Yep, a thousand dollars invested at 12% at age 20 will turn into a quarter million by the age of 68. So, aren't you sorry you blew the money? And, of course, if you keep adding to it regularly, you'll get filthy rich much earlier. But you must start now! I am 50. I'd have to invest $32,000 to get the same result a 20-year old will get for just $1,000. Too bad I didn't move to America much younger!
Now, just for the heck of it, how much would it grow at 18%? That's 72 / 18 = 3 years to double.
Age 20: $1,000
Age 23: $2,000
Age 26: $4,000
Age 29: $8,000
Age 32: $16,000
Age 35: $32,000
Age 38: $64,000
Age 41: $128,000
Age 44: $256,000
Age 47: $512,000
Age 50: $1,024,000
Age 53: $2,048,000
Age 56: $4,096,000
Age 59: $8,192,000
Age 62: $16,384,000
Age 65: $32,768,000
Age 68: $65,536,000
Well, don't salivate just yet. 18% is not easy to obtain on a regular basis. But guess who makes that much -- credit card companies. Now, do you understand why credit card companies are so willing to extend credit to college students, and why they only demand a minimum payment every month?
Compound interest can work for you and it can work against you. The choice is yours.