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“Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t….pays it.“ – Albert Einstein
Now that you are on your way to becoming a Capitalist I want to describe one of the greatest phenomena that occurs in personal finance.
The Capital Snowball.
Much like there is a tipping point in the Debt Snowball (as one debt gets paid off, there is acceleration in repayment of the remaining debts as more and more funds become available), there is a Capital Snowball tipping point.
Too often many physicians are at the wrong end of this financial phenomena.
I know.
I was one of them.
When I undertook the maximum student loans available I then made one of my famous financial mistakes of electing to ask (and receive) forbearance on the majority of the balance when I started residency.
Interest continued to accrue while I continued not to make any payments.
I even had the opportunity to pay the accrued interest before it compounded (i.e. became part of the principal which then would accrue it’s own interest charges) but elected not to.
It is not a good financial predicament to be in when the lender’s interest is itself earning more interest.
This path was indeed the path to making someone wealthy, but unfortunately that someone was not me.
The key therefore is not to be the borrower but the lender in this financial equation and take advantage of compound interest.
When you are a capitalist you are able to deploy/lend out your “seed” money through various avenues and then sit back and watch your original “money employee” work to create more money.
Water your “seed money” and watch it grow…
At one point in the building of capital, the income generated from previously deployed capital will add to the system at a higher rate than your initial contributions.
This income can be from interest, dividends, capital gains, etc.
The incoming money can then be redeployed in the original venture or can aid in diversification by being invested in other income generating opportunities.
“Money is a terrible master but an excellent servant.” – P.T. Barnum
…into a full fledged money tree
Once your capital snowball becomes a self-sustaining/self-feeding system, you have truly reached financial independence and can make money while you sleep.
This results in true financial bliss.
Superpower Take-home points:
- Get to the Capital Snowball tipping point. The system will take on a life of it’s own with only you as the beneficiary of its hard work
- Compound interest is the eighth wonder of the world and you need to be on the right side (lender) of the equation to benefit.
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Spot on. Once you have $1,000,000 in the accounts and they are earning 8% you are adding $80,000 to your sum of money each year simply by it existing. This is how the rich get richer. Wealth begets wealth. At $3,000,000 and 8% its $240,000 which is more than many doctors make! The thing that matters most – by far- when starting out has nothing to do with investment choices or asset allocation. It’s all about savings rate to let that capital snowball build momentum. Truly a helpful concept to think about! P.S. Like the new look much better! Thanks,… Read more »
Savings rate is absolutely key. And you hit the nail on the head about how at a certain level the system can be adding money in the 6 figure range. That is why they say the first million is the hardest to get to and the time to make the next million gets shorter and shorter. Appreciate the compliment on the new look. It’s a work in progress but I’m happy with how it turned out too.
This is the purest form of “passive income”. We can talk about real estate all day long but understanding the power and value of compound interest is the biggest step towards financial independence
Compound interest definitely makes someone rich. Banks have figured it out a long time ago. There is no reason why it can’t be applied to an individual level.
I can commiserate with you about being on the wrong side of compound interest. Not fun. Having compound interest work for you, on the other hand, is fun!
I agree. I have been on the very wrong side of the equation with my student loans and my forbearance debacle that made my lenders far richer than they should have been. I still shake my head that I took almost 22 yrs to pay it off from the day of signing the loans.
I can’t wait to watch the snowball pick up speed. A big milestone on the path to FIRE is when your returns start to outpace your new contributions. The sooner you get the ball rolling, the bigger it becomes.
Yes once it’s rolling downhill everything in its path better watch out.
The capital snowball is amazing. Once you get to a certain size, it takes a life of its own. The first 500K and 1 mil is the hardest. I used to think compound interest was great. But you know what’s even better? Using other people’s money to grow your own wealth. Real estate allows you to do that. ie bank’s money, govt’s money (tax benefits), tenants money (rent). Nice post.
Thanks MD. Yes leverage using bank money with real estate can really produce some eye-popping returns (my homerun deal of all time was my medical group building which was leveraged quite a bit). And the tax advantages for real estate investors are outstanding. That’s why the truly wealthy have lots of real estate in their portfolio.
You are absolutely right, understanding the double edged sword of compound interest is one of the most concepts in personal finance. It can all but guarantee your success or your failure depending on whether or not you make it work for you, or against you.
-Ray
Thanks for the comment Ray. In the beginning everyone is on the wrong side of the financial equation. But those that see the light get to transform from student to master. Once you achieve debt free status you are not letting anyone else profit off of you.
Hi XRV!
What a great analogy. Build a snowball and let her rip. I have a snowball, thankfully it’s not melting but I am unable to roll it for now. Our government is taxing passive income. I might have to ponder more RE again….
Is that a new tax law for you (was passive income not taxed in prior years?) and is it being treated the same as earned active income? In the US passive income definitely has preferential tax treatment compared to all the taxes piled on for our w2 earnings. Thanks for stopping by. Always appreciate it
Love this! You either enjoy the fruits of compound interest or you spend the rest of your life paying it to others.
You definitely don’t want to be stuck paying it… it grows to enormous amounts so quickly.
The magic of simple mathematics. Cheers!
Thanks got stopping by half life. I agree. First thing is to get rid of your debt using the debt snowball technique. After that there is really nothing stopping you from making another snowball this time directly benefiting you.
Indeed. It’s like being the opposite of an investor – compound interest will eat you alive. I’m glad you have the right perspective on it now.
Thanks Bob. Really appreciate the visit and comment. I don’t plan on going back to the dark side of compound interest ever.
The math behind compound interest starts to work as soon as a person starts investing. It takes time, however, to notice how powerful it actually is. For me, it seemed to take off after the first $250k in savings. A long bull market and a high savings rate is a powerful wealth building combination.
Thanks for stopping by and especially commenting. $250k does sound about right for when you first start seeing the capital actually make significant contributions to the system. As that number climbs the system really takes off (and you see exponential shortening in time to make the next 250k and so on).
What’s interesting with compound interest is that takes time before the snowball really gets going. After poring over compound interest graphs, it looks like year 7 is when things start to get exciting.
It’s good evidence to just start investing; the earlier the better!
That’s great tidbit of info about the 7 yr mark. My breakthrough moment was when the income from my capital met my yearly household expenses (happened last year). Pretty much allowed me to have the majority of my W2 income to be used to add even more capital to the pot.
Love the article! I wish that I had applied these principles early on, but financial acumen was not the topic of conversation during my residency and afterward. Keeping up with Dr. Jones was the theme. Better late than never. Thank you for, hopefully, helping the future generations navigate the shark infested waters,
( if they listen).
Thank you so much for the kind words. Don’t be too hard on yourself. As physicians it was almost like we were set up for failure with lack of any financial training despite decades of education. That coupled with the dramatic jump in paycheck from resident to attending (and years of delayed gratification already b/c of training) made it easy to justify big ticket items right off the bat. Fortunately with physician’s incomes still being quite large, you can dig yourself out quickly if you focus on financial improvement. Best of luck with your financial future 🙂