The Myth of Compound Interest: What’s Really Holding You Back
You’ve probably heard compound interest is the 8th wonder of the world.
I would agree it’s pretty great, as it can really do some amazing work.
However, most people completely misunderstand what it is and how it actually works.
Compound interest is the interest calculated on the principal amount plus any accumulated interest. This means you earn interest not just on your initial investment (the principal) but also on the interest that has already been added to your account
But is compound interest the same thing as compounding money?
Let’s look at a scenario for someone at the age of 35 going to 65.
They have $100,000 in an account at 5%.
Compound interest as you can see in the chart below would show that at the end of the 30 years you would have $432,194.
That’s compound interest.
Compounding money, unfortunately, doesn’t work like that.
We live in what’s called the real world. And in the real world, there are costs associated with our decisions.
We call these wealth eroding factors. These are things like:
Taxes
Fees
Inflation
Lost opportunity costs
Volatility
In this article, we’ll look only at taxes, inflation, and lost opportunity cost.
We won’t look at fees, volatility, or term insurance costs.
Now, looking at the same 30-year period on that $100,000 at 5%, we need to understand the costs of that decision.
Our starting balance here is: $432,194.
It obviously depends what our fictional investor invests in. But let's say that in this scenario, they pay taxes each year they earn interest.
Let’s say taxes were 20%. Over the 30-year period, they would pay $66,439 in taxes, from a different account.
Why from a different account? Because if they took it from this account, they wouldn’t be compounding. They would be netting the account.
Since they paid these taxes, that also means they lose out on all the growth they could have had if they didn’t have to pay the piper.
At a cost of money rate of 5%, that’s not only $66,439 in taxes, but another $57,045 in LOST OPPORTUNITY COSTS on those tax dollars over that 30-year period of time.
We’ve all felt the pressure of inflation. But when we’re shown the big number of what our accounts can grow to, we often forget about what inflation does.
With an inflation rate of just 3%, their $432,194, spends like $178,058.
Let's add up the costs of this decision to compound our money:
Principal: $100,000
Taxes: $66,439
Lost Opportunity Cost on Taxes: $57,045
Inflation: $254,136
Total Cost of Decision: $477,620
Total Account Balance: $432,194
If this was a business, do you think you could franchise it?
Compounding interest and compounding money can be very easy to get mixed up.
But here in the real world it’s important we recognize the two. Because now that we’ve recognized the difference and why there’s a problem, we can do something about it.
In an upcoming article, I'll reveal why the solution is more money and how you can get more money with less costs.
Stop leaking money to fees, taxes, and inflation.
Download our free Save 28% Guide to learn the proven system that helps high-income earners keep more, build more, and finally feel in control—without budgeting.
