The 12 Secrets of Self-Made Multi-Millionaires (12 Lessons)
The Compound Interest Effect
(Please listen to the audio file first! It is more in-depth. Then study the text and take any action that the text suggests!)
The Fifth Secret of Self-Made Multi-Millionaires is that they understand and employ compound interest.
Understanding the compounding of interest, over time, via the use of discretionary income both as debt and assets, is one of the most critical components in building financial security. Financier Baron de Rothchild said, “I don’t know what the seven wonders of the world are, but I know the eighth wonder of the world is compound interest. Even with very low interest rates being paid on savings’ accounts, the concept of compounding interest, over the longest time period possible, is still one of the greatest secrets of wealth accumulation.
Manhattan Island was sold by the Manhattan Indians in 1626 for about 24 dollars worth of cloth and beads. Had they invested that 24 dollars, at even today’s very low interest rates, the tribe would have accumulated enough money to buy back all of the properties in Manhattan at today’s market prices.
Americans, typically, save less than four percent of their take-home pay. They view extra money as disposable income and hasten to dispose of it. They buy now and pay later, if ever. They owe more on their automobiles than they’re worth when they go to sell them.
If you want to be a multi-millionaire, you need to get rid of disposable income thoughts. Never again ask how much the monthly payments are.
Monthly payments are full of interest and finance charges. Embrace the discretionary income attitude of Asians, Canadians, British, Europeans and newly arrived immigrants. They save an average of 14 to 25 percent of their incomes.
Here are some action ideas to make compound interest work for you instead of against you:
- Make a commitment to pay 10 percent, if possible; or if that’s not possible, at least 5 percent of your take home pay as your first mandatory payment each month.
Put that amount into a mutual fund or other appreciating asset and consider that account untouchable. No vacations from it. No gifts. No down payments on homes or cars. No college tuition. For my family, I call it our life mortgage payment, amortized over 30 years. If we don’t pay it on the first of every month, our future will go into foreclosure and we’ll end up living in a senior center or in a relative’s home as a stowaway.
The best way to harness the power of compound interest is to start saving as early as possible. Using the Dow Jones rate of return, you’d only need to save five dollars a day to accumulate a million dollars over the 43 years between college and retirement!
That’s the Big Mac or Whopper and fries you shouldn’t have eaten, or the Starbuck’s latte you could have done without. Compound interest works for you or against you. Don’t use credit cards with high interest rates to pay for depreciating assets.
Use your precious credit wisely and pay interest only on appreciating assets, or use credit cards strictly for business expenses. Never simply pay minimum balances. If you do, you’ll pay double or triple the original cost and never be able to recover your investment. Call your bank tomorrow and ask them for a lower interest rate on your credit cards. You’ll be surprised that many will if they think they’ll lose you to a competitor. Consider consolidating your credit card debt into one account with a much lower rate. Consumer Reports lists those institutions with the lowest rates. Making additional principal payments on your home mortgage is another sure way to create higher net worth.
Money compounds over time, so you can use your discretionary income as a stairstep, trickle down, incremental program.
The younger you are, the less you have to put in each month, and the lower the return you need to become financially secure. Financial security is the value you place on the time of your life. You need to define the quality of life you’re seeking first, and then compute how much it’s going to cost to finance that quality, with a standard of living that can be maintained without continuing your current employment. That’s the bottom line.
In your mind, picture your life as a stairway you are walking down, with five steps to fulfillment. Instead of an uphill climb, view it as a downhill hike, walking carefully and surely.
Complete this picture by placing five large empty buckets on each of the five steps and label them from the top bucket to the bottom: Survival, Stability, Quality, Security and Independence. This is what I call the “Overflowing Buckets Concept” of creating financial independence. It’s like Abraham Maslow’s hierarchy of needs by putting first things first in their order of importance. The object is to fill each of the five buckets full of dollars as you progress down the stairway, so that when one bucket overflows, it spills into the next bucket down on the next step. Bucket One, the Survival Bucket, is how you budget your basic needs of food, shelter and basic existence. Over your cost of living, any extra money flows into Bucket Two, which is the Stability Bucket. Financial stability is the ability to remain solvent in the event of sudden, unforeseen changes and emergencies in your life. It is called insurance against catastrophic loss. It means having an emergency fund in a savings account equal to a minimum of three months’ income, preferably six months’ income. It includes having adequate medical insurance that remains in force regardless of your employment status, that is permanent and transferable. Another important component of financial stability is life insurance, consisting mostly of term insurance while you build your assets, with some whole life, that accumulates cash and loan value and is level premium. Many people purchase split dollar policies that afford the low premiums of term, and appreciation tied to mutual funds rather than low interest rates.
An important part of your stability program is non-cancelable, individual disability income insurance, equal to 70 to 100 percent of your monthly income. One of the greatest financial blunders most people make is to assume that insurance against premature death is all they need, besides health, home and auto insurance.
The likelihood of loss of income due to injury or illness is much greater than loss of life. Not only are you without income when you are sick or injured, you also need to be cared for and the expenses continue to mount even though you’re not able to work.
The next Bucket you need to start filling after Survival and Stability, is the quality of life bucket. This is where you sit down with significant others and determine what standard of living will give you the quality of life you desire: The home, possessions, education for children, recreation and vacation. These items should be budgeted and saved for, rather than put on credit cards.
Once you have established a savings habit for your quality of life, a little discretionary income should also be set aside for bucket four. This is the financial security bucket. Financial security is defined as the amount of assets in dollars, that will give you the amount of monthly income you need for the quality of life you desire, at some pre-determined point in the future, without having to depend upon day-to-day employment.
Less than 5 per cent of Americans ever fill this bucket. Your goal is to be in the top five percent who do. To get in the top five percent club, you need to put about 10 percent of your spendable income into an appreciating investment fund at the first of every month, like a utility bill or mortgage payment. Treat it as the most urgent bill you need to pay.
The fifth and final bucket at the bottom of the stairs is financial independence. This is achieved when you beat the target date you set for retirement. Personal freedom is when work is a choice not a necessity, when you can do what you want, when you want, and your health and energy levels enable you to do virtually anything you desire. Being free to chase your passion, not your pension is one of the greatest goals you can set and reach.
Self-Test: Using the definition of Financial Security we have stated above, what amount of assets will you need to give you a guaranteed income, after taxes, at your desired retirement age to live comfortably without depending on working or the government? This is an extremely important exercise, not matter what your current age.
The Science of Getting Rich • The Richest Man in Babylon • Acres of Diamonds
Section Review Quiz and Answers
The 12 Secrets of Self-Made Multi-Millionaires (12 Lessons)