Remember all those complex mathematical equations you learnt in school?
The stuff you’ve never used a day in your adult life, like algebra and obtuse angles?
Well, while teachers were busy filling your head with theories from ancient Greek ‘thinkers’ such as Pythagoras, there was one formula they probably didn’t give anywhere near enough class time to.
Thankfully, when we grow up we can choose what to fill our own heads with.
And while you might have determined to never study any sort of ‘maths’ again, I can guarantee this equation is well worth learning.
Moreover, if you apply it to your everyday life, chances are your entire relationship to money will change dramatically – for the better.
Albert Einstein called it “the greatest mathematical discovery of all time.”
It’s compounding interest.
And with it, you can build your very own property empire that would make the Ancient Greeks green with envy!
What is compounding interest?
The best way to explain how compounding interest works, as with any other type of equation, is by playing with some numbers.
Let’s say you invest $10,000 at 6%.
In one year, that $10,000 has become $10,600 – pretty simple maths.
But what happens if you reinvest that entire $10,600 – your initial capital and the gain realised – for a further year at 6%?
After the second year, you’d be up another $636, with your investment now worth $11,236.
In other words, you’ve gained not only that $600 from the first year, but another $36 on top.
This is the power of compounding.
Okay, so an extra $36 over 12 months might seem like chump change.
But remember, every time you reinvest that little bit more, it continues to snowball.
By the end of year three, your investment is worth $11,910 because it netted an additional $674, which means your yield was $74 more than in your first year of investment.
And best of all, you didn’t have to life a finger to make that happen!
Compounding did all the work for you.
Or more accurately, time and leverage – the fundamental backbones of compounding interest – did.
If you want to delve deeper into the wonders of compounding mathematics there’s an interesting commentary from Dr. Shane Oliver where he explains why compounding is actually an investor’s best friend.
Sooner rather than later
Of course, given that time is the most essential element in this equation, the more you have of it, the more effective compounding will be when it comes to building future wealth.
Logically, when it comes to residential real estate as an investment vehicle, the longer you hang onto it, the more it appreciates in value.
And with property you have a combined compounding effect; reducing your debt by paying down your loan, even as your asset is making capital gains.
And of course you don’t pay tax on the capital gain while your equity is compounding – another factor that accelerates growth
Plus the benefit of time means your debt is worth less….
Think about it – your $500,000 mortgage may seem a significant sum today (and it is.)
However in 10 years time when the value of your property may have doubled and your still have a $500,000 mortgage – the cost of servicing it in future dollars could well seem insignificant.
I remember the first mortgage I took out was for $18,000 (back in the early 1970’s. I had no idea how I was ever going to pay that off and took a 30 year loan!
Compounding and housing – a match made in investment heaven
Property investment and compounding interest go hand in hand.
If you intend to build a profitable residential property investment portfolio, strong capital growth that compounds should be a major consideration when selecting an asset.
Get it wrong and you effectively rob your portfolio of the potential to grow quicker and stronger.
Remember, it’s capital (your equity in the property) that compounds with time.
Diluting either essential ingredient by failing to give yourself enough time in market or buying a second grade investment (with lower growth) is like starving your ‘money tree’ of essential nutrients.
If you want a healthy, thriving, green as green can be money tree, nurture it with the right type of compounding love.
It will pay you back in spades!