The Simple Formula to Earning Your First Million
What can you do with one million? You may say you’d spend it all in one day — perhaps to buy a car, or acres of land. You can spend it in a shopping spree, or invest the lot of it. Whatever your answer, one thing is for sure. Earning your first million is infinitely harder (and would definitely take longer) than spending it.
Rather than trying your luck in lottery, why not let your money earn more money. One awesome way of reaching your cash target is through harnessing the power of compounding interest. You’ve probably heard the term thrown a lot, in fact, we’ve highlighted its use on a number of occasions. We’ve shown you how compounding interest helps you on retirement, on investments, in paying for yourself first, even with your kids.
How does compounding interest work?
Investopedia defines compound interest as “the interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan.” Simply put, you can think of it as earning “interest on interest.”
Therefore in theory, the longer you let your money sit, the more earnings you’ll have in the future. Imagine yarn spun into a ball. If you start with a single strand and spin continuously, it’ll soon grow the size of your palm. The longer you spin, the bigger it will get, and before long, the ball would have swelled to the size of your head, or your (hubby’s) tummy.
One important element at play here, which made your ball of yarn turn into such a giant watermelon, is time. If you had stopped spinning after a few rotations, the ball would’ve remained the size of a grape.
To better illustrate how time, when combined with interest, grows your money, and how to maximize this, consider this scenario.
Three persons each decided to leave a one-time investment of P25,000 at an instrument with an annual interest rate of 4%. One person is 25 years old, another is 30 years old and the last person is 40 years old. Because of compounding interest, by retirement age, all three persons would’ve more than doubled their initial investment. In fact, the 25-year-old who left his money to grow for 35 years would’ve almost quadrupled his investment.
Even though the three started with the same amount, and grew their money at the same rate, since the youngest person has more time to grow his money, his earnings is double of the eldest. By the time the 25-year-old retires, interest would have grown his money by an additional P77,598.31, compared to the 40-year-old who would be earning considerably less at P31,969.20 on top of his original investment. This is the main reason why financial advisers and investment gurus teach you to start investing early.
F = P (1+(i÷n))nt Where P is your principal amount; i your interest rate, t your term or time, and n your compounding frequency. If you’re computing for interest compounded annually, the compounding frequency will be 1, 2 for semi-annually, 4 for quarterly, and 12 for monthly. Using the example above, to get the future value of the 25 year old by the time he retires: F = 25,000 (1+(0.04÷1))1×35 = P98,652.22
F = P (1+(i÷n))nt
Where P is your principal amount; i your interest rate, t your term or time, and n your compounding frequency. If you’re computing for interest compounded annually, the compounding frequency will be 1, 2 for semi-annually, 4 for quarterly, and 12 for monthly. Using the example above, to get the future value of the 25 year old by the time he retires: F = 25,000 (1+(0.04÷1))1×35 = P98,652.22
So, how do you earn your first million?
You may be quick to point out that while time plays a hand at growing your money, P100,000 is still a long way to P1 million. True, because time is only one variable in the equation. In order to grow your wealth faster, you also need to add to your investment. Consistency is the key here. Growing your base will, in turn, increase the interest you earn.
Let’s go back to our investors, imagine if all three of them added to their initial investment annually until the time they retire.
For a minimum of P18,000 annually, or P1,500 per month additional investment, both the 25-year-old and 30-year-old would be millionaires by the time they retire. Meanwhile, it’ll take double the effort out of 40-year-old to reach the million mark, once again highlighting the effect of time on a person’s earnings.
F = P (1+(i÷n))nt + A ((1+(i÷n))nt)-1)÷(i÷n)
If you notice, the first part of the formula is the same as above. The second part accounts the additions to your investment, where A is the additions. Make sure to keep your time consistent if you’re calculating monthly, quarterly, or annually. Using the previous example, with an additional 1,000 investment per month, F = P98,652.22 + P12,000 ((1+(0.04÷1))1×35)-1)÷(0.04÷1) = P982,478.92
Let us warn you though, as simple as this sounds, you will need an enormous amount of patience and discipline to pull it off. And while these projections seem attractive, it will take effort and careful planning on your end to keep consistent, or grow your interest rate annually. Depending on your choice of investment instrument, interest rates fluctuate on a regular basis, which could potentially accelerate or derail your way to millions. And don’t forget to factor in fees, taxes, and inflation in your calculations to have a more or less accurate picture of how much you’ll be earning.
But once you get a knack of it, you can let compounding interest work its magic. As business magnate and investor Warren Buffet said about compounding interest, “the big sums start accruing toward the end.”