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Secret 3 : Make Your Savings Multiply.

Money that flows to you as a result of an investment is also called your return on investment (ROI). 

The third secret is to always reinvest the returns on your investments. As you will soon see, it is the power of compound interest that will accelerate your personal wealth. 

When you invest there are two investment terms that you need to be familiar with. 

The first is simple interest

Simple interest is the interest (or return) that your cash investment generates. It can be calculated by first multiplying your investment by the annual interest rate. This gives you the amount of interest that you will receive each year. If your investment is for less than a year you then need to multiply your annual interest by the number of days of the investment period divided by 365.

Let's take an example:

$1,000 cash invested at 10% per annum would return $100 in interest at the end of the year. If the investment was for 90 days then we would need to multiply the $100 by 90/365, so our interest would now be $24.66. 

  • Once you earn a return you have two options:  Your first option is to take the return and spend it. You can either reinvest your initial deposit or spend that too. You will find great difficulty multiplying your savings if you continually spend the income it generates.

  • Your other option is to reinvest part or all of the income your investment has generated. When you do this you are taking advantage of the power of compound interest, the second investment term you need to be familiar with.

Using compound interest, your initial investment and some or all of your return is reinvested. This way your initial interest earns more interest. And once that investment matures and you reinvest, your initial deposit grows. 

Using compound interest to your best advantage

Compound interest is most effective where you have multiple compounding periods in one twelve month period. Let's take an example. You have $1,000 to invest and a choice of two mutually exclusive investments, which are outlined below:
 

Investment Option 1 Investment Option 2
10% per annum, with interest paid annually in arrears. 9.8% per annum with interest paid monthly in arrears.

Which one would you choose? 

Option 1 returns to you $100 ? so that at the end of the year you would have $1,100.

Option 2, even though it has a lower interest rate, returns to you $102.52, $2.52 more. The reason for this is that with option 2 your interest after the first month is calculated and added to your initial investment for the second month. In the third month, your interest is calculated on your initial investment, plus the first two months interest. In other words, you get interest on your interest. This is compounding. You may be thinking "$2.52, who cares?". Let's look at what happens over 10 years. Making no further capital advances, the value of each investment is

  • A. $1,000 if you spent rather than reinvested the interest
  • B. $1,594 if you reinvested annually at 10% per annum, compounding annually
  • C. $1,654 if you reinvested annually at 9.8% per annum, compounding monthly

Taking Option B, by simply reinvesting your returns your investment would be 59.4% per cent higher than Option A.

A note here is that although the interest rate on Option C was 9.8%, it had an effective interest rate of 10.52% - because of the effect of monthly compounding. When looking at various investments be sure to note the differences between nominal and effective rates of return. 

Charge card providers know about the power of compound interest. If you read the terms and conditions of your credit card it is likely that they will advertise the nominal rate. However, if the interest on your card is charged monthly and your minimum repayment is less than the interest charged, you will find that the compounding effect is pushing you further into debt.

What rate of interest is does your savings account attract? How often is interest paid? Compare this with your charge card. Do you benefit or bleed from the effect of compounding?

Always reinvest your returns and avoid spending your investment at all costs. 

Action Steps For Immediate Results

  1. Make sure you understand the difference between simple and compound interest.

  2. Look at your regular savings account. How much interest are you earning? How is it calculated? Try and find out if there is a better deal available.

  3. Make sure the returns on your investment do not go into your "spending" account. Either:
    • reinvest your return in the same investment if you are rolling it over, or
    • put the return in a special account that you won't be tempted to access.



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