If you have ever taken a finance course or watched the magic of compounding in action, it is like magic. What starts as a tiny amount, grows incredibly large over long periods of time. One of my favorite discoveries in finance was the rule of 72. This rule says take the number 72 and divide it by the interest rate you expect to return. Let’s use 12% for an example. 72 divided by 12= 6. What exactly does the answer 6 give us? This is the number of years it will take to double your money.
Let’s say you are an average investor achieving a 12% average annual return. You start with $25,000 at age 20. By age 26, your assets would be around $50,000 assuming you did not add or subtract from your original amount. At age 32, the assets would grow to approximately $100,000. By 38: $200,000, by 44: $400,000, by 50: $800,000 and to $1,600,000 at age 56. This of course is a simple illustration, but it shows the magic of compounding. Like a snowball that starts out small, the investment starts out small and becomes gigantic as it rolls down the hill. Compounding is a great friend when you are investing.
Now it’s Tragic!
When you borrow money, compounding becomes a horrible enemy because it works against you. What started out as a small amount you are borrowing turns into a great sum over time. Instead of the rule of 72 seeming like magic, it becomes tragic. You create a nice huge profit for the lender, who basks in the glory of compounding while collecting all of your interest to the bank. The bottom line: Don’t borrow unless you absolutely have to, even then look for alternatives. Borrowing money is easy; paying it back is the hard part