If you missed it and are just dying to read about tax issues last weeks topic was acquisition indebtedness. This weeks topic is the effects of compounding which many people incorrectly refer to as “the velocity of money”. The velocity of money is actually a term that economists use in reference to the number of times a dollar is spent within a given period of time. Regardless of what you call it, compounding is a topic that we all hear a lot about but many don’t understand its actual effects and how you can use it to change the course of your financial future.
To illustrate the effects of compounding I will offer you a job. This job lasts for 30 days and there are two compensation plans: Plan A is a flat pay rate of $100,000 for the 30 days. Plan B is 1 penny per day double everyday for the 30 days. Which plan would you select? If you selected Plan B you made a very good choice as at the end of the 30 days you would have $5,368,709! While an extreme example, this is the effect of compounding. In last weeks post we discussed the effects of your mortgage interest deduction and how important it is to take tax ramifications of any investment into consideration. So lets see what the effects of taxing your penny a day doubled everyday would be. Well assuming that you are in a 25% marginal tax bracket, at the end of the 30 days if that penny was taxed before it was doubled you would only have…..$958.76. Ouch! Here is the math if you care to check it. The Penny Story
Another More Realistic Example:
Say you invest $2,000 a year for 10 years from the time you’re 22 until you’re 32 in a
qualified retirement account. Then you stop investing and let the money compound at 10 percent for 28 years until you’re 59 1/2, which, may be the first time you can remove it without penalty. You’ll have $505,629 after contributing a total of $20,000 and letting it compound. Nice.
On the other hand, if you wait until you’re 32 to begin investing and you put away $2,000 a year for 28 years until you’re 59 1/2, you’ll only have $295,262, even though you’ll have contributed a total of $56,000. Since money compounds more the longer you leave it in your account, it makes sense to start as early as you can. Don’t worry if it is already late in the game for you, as future posts will discuss ways that might help you catch up.
The Rule of 72
There’s an easy rule you can use to work out how your investments can grow with compound interest. Simply divide the rate of return you expect to receive into 72. The result tells you how long it will take for your money to double without further savings.
For example, you have $10,000, which is earning 6% interest (after tax). 72 divided by 6 = 12. Every 12 years your $10,000 will double, so:
After 12 years you have $20,000
After 24 years you have $40,000
After 36 years you have $80,000
While just a general “rule of thumb” you can use the rule of 72 to remind yourself of the power of compound interest.
The effects of compounding and taxes on your ability to accumulate wealth are the reasons that all financial gurus are constantly telling us to pay ourselves first and invest in qualified retirement plans like 401Ks and IRAs.
So how does this effect your real estate purchases? That is next weeks topic which is:
Why no method of applying extra principal payments to your mortgage is the wisest or most cost-effective way of paying off your house! Stay tuned…..