By Doug Andrew
When I teach audiences across the country about the “Three Marvels of Wealth Accumulation,” I explain the principles the affluent have used for generations: 1. Compound interest, 2. Tax-favored accumulation, and 3. Safe, positive leverage. The first of these marvels, compound interest, can make an enormous difference in how your money grows. But it has power beyond your finances — by applying “compound interest” on your “KASH,” you can make a lasting difference on the legacy you leave behind. More about that later.
First, let’s look at how compound interest works with your money. Many people think they understand interest. They know it’s the amount that a bank or credit union pays you for the privilege of “holding” your money (which the bank then invests or puts to work). Conversely, it’s the amount of money you pay the bank for using its funds, with tools like business loans or mortgages.
But what many don’t understand is there are two methods of computing interest — simple and compound. When you borrow money for your house or your business, it is usually calculated as simple interest as you make payments on the debt. When you invest money in your business or other safe investments, you should earn compound interest.
The difference between simple and compound interest can be the difference between paying hundreds of dollars per month on a simple-interest, declining balance that may be tax-deductible, versus accruing thousands of dollars that climb exponentially in a business or financial vehicle that provides compounding interest.
Here’s why: A simple interest-only monthly payment on a line of credit is calculated on the balance owing. But when you earn compound interest, you make money not only on your original investment, but also on your accumulated gains.
As an illustration, on a $100,000 loan at 6.5 percent tax-deductible interest, the interest-only annualized payment would be $4,333 net in a 33 percent tax bracket. If you were earning a net of 8.5 percent after tax (or, better yet, tax-free), your first year would yield $8,500 on the $100,000 invested. After 30 years, the total of annual interest cost would be only $130,000. But earning 8.5 percent compound interest on $100,000 would net you (after deducting the cost) well over $1 million profit. A million dollars of profit can be earned with what appears to be just a two-point spread in interest.
That takes too long, you say? Let’s add a few zeros. The last eight years, many business owners that I coach have been using business lines of credit at 4.5 percent tax-deductible interest. On a $1 million loan, the annual net cost of the interest (let’s use a 33 percent tax bracket again) would be 3 percent or $30,000. In the meantime, they have been averaging more than 9 percent annual return (tax-free) on the $1 million. At 9 percent that would be $90,000 in annual interest the first year. But then it continues thereafter to compound. The second year, 9 percent interest would be credited on $1,090,000. Put another way, as a business owner, would you hire an employee for $30,000 if that employee helped you earn an additional $90,000? Would you invest in a widget machine at a cost of $30,000 if that widget machine made you an extra $90,000? That would be a 300 percent return on employment or equipment cost.
Here’s an analogy, one you might want to use the next time you’re on the golf course. Ask your pals when you’re starting a round, “Hey, what if we bet 25 cents on the first hole, then doubled it every hole?” They’re likely to say yes — until you let them know that would mean they’d owe $32,768 if they lost the 18th hole alone.
People who understand the dynamics of money — those who realize how money invested and left to earn compound interest can burgeon into wealth — are more likely to be making headway toward an abundant retirement. This is why I favor financial vehicles that employ compound tax-free interest.
Now let’s apply this principle to your “KASH.” In my book, Entitlement Abolition, I share that KASH is an acronym I use for Knowledge, Attitudes, Skills, and Habits. I teach how important it is to accrue more KASH in our lives, by making wise choices, learning from our mistakes, adding to our abilities, developing our talents and letting go of self-defeating behaviors.
It’s not enough to earn the KASH for ourselves. Just as with financial wealth — our cash — that we want to share with our children and grandchildren, we also need to pass along our KASH. To do so, we need to make “deposits” in our family’s “legacy bank.” We need to write down our experiences and wisdom, keeping a record of what we’ve gained.
But to really make a lasting difference in our family memebers lives, we need to apply compound interest on that KASH. We need to teach our children and grandchildren to double the deposits we’ve made, to take what we’ve learned to the next level by incorporating these principles in their own lives. Then as they return to the family’s legacy bank and make their own deposits, the family’s wealth grows exponentially.
Imagine what all your family’s knowledge, attitudes, skills and habits will look like, compounding over two generations, three generations and beyond. Start now to not only make your own deposits in your family’s legacy bank, but also to leverage the power of compound interest by leading your family to do the same.
Doug Andrew is a best-selling author, radio talk show host and abundant living coach.