Albert Einstein is often credited with saying that “compound interest is the most powerful force in the universe.” Whether or not he actually said this, it remains an idea of abiding truth.
For most people who aren’t lucky enough to start the next Microsoft or Facebook, the best chance of acquiring real wealth in their lifetimes will be through the effects of compound interest and its financial cousin, compound returns. Most people simply don’t appreciate how powerful the effects of compounding interest and returns can be for those to whom they accrue. Nor do they often appreciate how detrimental they can be to those who must bear the burden of paying for them, as in the case of borrowers.
Understanding the power of compounding returns may be the most important single financial idea that anyone will ever learn. To illustrate the incredible power of compounding returns, of which compound interest is a subtype, it’s instructive to look at the case of Warren Buffett. Warren Buffett started his investing career in the mid-’50s. Over the next 60 years, he returned around 20 percent per year. Today, Warren Buffett is the second richest man alive, with a fortune of over $70 billion.
But how much might someone have made if they were able to invest $1,000 with Mr. Buffett at the start of his career? Since he returned about 20 percent over around 60 years, the answer is 1.2^60*1,000 or $56 million! If someone would have invested $100,000 with Buffett at the start of his career, they would have been among the richest people alive today!
Such is the incredible power of compounding returns. But the interest that banks charge is different from compounding returns only in degree. This leads to a related and important conclusion. From the standpoint of the borrower, taking a loan is the exact opposite of compounding financial returns in the market. And unlike in the case of the stock market, bank loans, consumer debt and debt generally are a zero sum game. There’s no rising tide lifting all boats, as in the case of American industry. There is only one party making payments to another party. This is the reason why so many homeowners are shocked to find out that they have paid 2 or 3 times the principal amount in interest, upon completion of a 30 year home loan.
But it also leads to one of the most important conclusions in personal finance. Debt should always be avoided at all costs. Debt is the single most destructive force to anyone’s ability to build wealth. There are two equally important reasons that make incurring personal debt the most pernicious financial decision that one could ever make. The first is the direct effect that debt has. As we saw earlier, accumulating debt is effectively the opposite of compounding returns. By itself, it can destroy what wealth one already has.
But the second reason is even more powerful. Personal debt makes it impossible to begin compounding returns. In a game like stock market investing, where nearly every player wins huge over the long term, the most important step you can take is to start playing as soon as possible.