Albert Einstein once referred to compound interest as the 8th wonder of the world.
Saying he who understands it earns it; he who doesn't pays it.
And he couldn’t have been more right.
Today we’re going to be looking at the miracle that is compound interest and how it relates
to the #1 killer of your wealth.
Let’s get started.
So the #1 wealth killer is debt.
Yeah, I know, big shocker.
But it’s really true and today we’re going to look at why that is.
The long and short of it is that having too much debt limits your most powerful wealth-building
tool... your income.
Now you may think that paying off your debt instead of investing would be a bad idea because
compound interest is so powerful.
And compound interest is powerful.
It's so powerful that I made an entire video dedicated to it.
It's also one of the first examples financial advisors will use with prospective clients.
The example usually goes something like this: Jane invests $100 a month ($1,200 a year)
from the age of 18 to the age of 25.
She earns 10% per year on average with her investments.
By the time she stops investing at the age of 25, she will have a little over $15,000
in her nest egg.
Over the course of the next 45 years, those investments will continue to grow.
Assuming that it continues to grow at an average annualized rate of 10% per year she will end
up with $1.1 million in her portfolio at age 70.
That's all achieved with eight years of investing $100 a month.
Jane becomes a millionaire by investing $9,600 of her own money.
On the other hand, we have John.
John doesn't start investing at age 18.
Instead, he starts at the age of 26 (just after Jane had finished all of her investing).
He also invests $100 a month.
However, unlike Jane, he does it from the age of 26 all the way until the age of 70.
John invests $54,000 of his own money over the course of those years and ends up with
a nest egg of just under $950,000.
So John ends up with approximately $150,000 less than Jane.
This is in spite of the fact that he invested six times more of his own money than she did.
What's more, is that even if you extended this example further John will never catch
up with Jane.
If John kept working and investing $100 a month all the way to the age of 100 Jane would
still have more money than him.
In fact, her lead would be even larger than it was when they were 70.
At the age of 100, Jane would have $19.2 million to her name.
John would have $16.7 million.
That's pretty incredible.
It's why Albert Einstein called compound interest the 8th Wonder of the world.
However, comparing someone whose income is being consumed by debt payments against someone
who is debt-free isn't going to be an apples-to-apples comparison.
One is able to invest a little and the other is able to invest a lot.
Let's take a look back at the example we just went over.
Jane invests $100 a month for 7 years starting at the age of 18.
She ends up with a net worth of about $1.1 million at the age of 70.
Just for the sake of keeping the examples consistent let's say that John still doesn't
invest for those first eight years because he's paying off debt.
If, by paying off that debt, he managed to free up an extra $200 a year (less than $17
a month) for investing he'd come out ahead of Jane by the time they're both 70.
If he freed up any more than that he would pass Jane even earlier.
And given the state of the average American debt situation, $17 a month in payments is
a remarkably conservative estimate.
According to articles in business insider, CNBC, and Forbes the average American debt
situation looks like this:
About $9,000 in credit card debt which is often split between several cards.
$30,000 in student loan debt.
And assuming a used vehicle was bought a little over $21,000 on a car loan.
That's around $60,000 in total debt.
If we assume 18% interest on the credit cards and 4.5% interest on the other loans and terms
of 5 and 10 years on the car loan and student loan respectively, the minimum payments could
be roughly $900 a month.
Freeing up that much cashflow could make a tremendous difference in the previous example.
Let's look back at John's situation from before and assume that his household's debt situation
was that of the average American.
John uses his $100 a month of excess cash flow to pay off these debts.
Based on the numbers it would take him roughly six years to become debt-free.
This is assuming he did not work any extra hours or sell anything to get out of debt
faster.
Once he was debt-free he would have almost $1,000 a month left over to invest.
If he starts the process of becoming debt-free at the age of 18 when Jane was starting to
invest he would have become debt-free by his 24th birthday.
If he then turned around and started investing the full $1,000 a month he would actually
be further along in his investments by his 25th birthday then Jane was.
Granted this is largely because he has invested more money than Jane has at this point.
Jane by her 25th birthday had only invested $8,400.
That's quite a bit less than John's $12,000 but think of the potential payoff of this
down the road if John keepS investing that money.
He’ll also likely be able to lead a much better lifestyle than Jane in the present
due to his lower monthly expenses.
Jane may eventually equal him in that regard if she gets her debts paid off, but for those
first several years after John is debt-free, it is worth noting.
Remember, compound interest is an incredibly powerful mathematical force.
But it can work just as hard against you as it can for you.
So it’s important to make sure that compound interest is your ally in your finances, not
your enemy.
So with that being said how do we avoid this killer of wealth?
First, if you're lucky enough to not have any debt right now research some ways to ensure
that you keep it that way.
If you're planning to go to college look into ESA or 529 plans.
They are ways to start saving for college while lowering your tax burden (which is always
a nice perk).
Also, look into scholarship opportunities or PSEO.
Don't be afraid to have a summer job and work during the school year part-time.
For the record, this can also be a good option in high school to give yourself a head start
financially so long as it doesn’t take away from your studies too much.
Make sure that you always have an emergency fund.
It should contain three to six months worth of expenses so that you don’t have to take
on debt for those moments when life happens.
Make sure you have insurance for those catastrophes that you wouldn't be able to cover with your
savings.
Catastrophic health emergencies are a good candidate for this.
If you're already in debt, learn about how people have paid off their debts.
Then choose the strategy that is most likely to get you (and keep you) completely out of
debt.
Three of the most popular strategies are the debt snowball, debt avalanche, and debt tsunami.
I have done videos on all three of those and they will be linked in the description.
The debt snowball is the one made famous by financial personalities such as Dave Ramsey.
It has you order your debts from smallest to largest balance and pay them off in that
order regardless of the interest rates on those debts.
The plus side is the momentum you can build up for yourself by quickly wiping out those
bills.
The downside is it isn’t the most mathematically efficient way to get out of debt, all else
being equal.
The debt avalanche is the more mathematically efficient option if you can stick to it.
It has you order your debts from highest to lowest interest rate and pay them off in that
order.
This is regardless of the size of the loan itself.
The upside is the fact that you’ll be paying less in interest.
The downside is in some situations it may take quite a while to get rid of that first
bill.
For those who are more motivated by seeing the balances of the debts themselves going
down this may not be much of an issue.
For those that are more motivated by the lowering of bills, this could be an issue in some situations.
The debt tsunami has you order your debts from the most emotionally stressful to the
least emotionally stressful and pay them off in that order.
In some cases, this could mean paying off the largest balance that also has the lowest
interest rate first.
However in my experience that is not commonly how it goes.
Most of the people that I've seen use this strategy tend to use it because there are
personal loans between family or friends that are causing a lot of stress in the relationship.
The person with the debt uses the tsunami to get rid of that loan first and then often
switches to a different strategy such as the snowball or avalanche.
Which is another viable option for many people.
There's nothing stopping you from starting with one strategy that will help get you going
and then switching to another that will work for you longer-term.
I know a lot of people who have started with the snowball to get themselves some momentum
and then switched to the avalanche once they were on a roll so that they could save on
interest.
Another thing I would recommend looking into is the power of the debt snowflake.
If you haven't heard, the debt snowflake is a strategy where you find ways to free up
money (or just happened to find the money) that you can put towards your debt payoff
strategy.
The nice thing about it is it works well with any of the other three strategies I mentioned.
While by itself it isn't game-changing it does help your primary strategy do its job
a little better.
And as we know every little bit helps.
If you need more motivation make sure to check out Dave Ramsey's YouTube channel and their
debt-free screams playlist.
It's filled with a lot of amazing stories of people paying off loads of debt on various
levels of income and getting to see their relief when they are finally debt-free is
very inspiring.
You might also find their Turning Points playlist interesting.
It is essentially interviews of people who have become debt-free talking about what made
them decide to go through that process and achieve that lifestyle.
I'll leave a link to both playlists in the description as well.