There’s a wealth accelerator available to every single person in the world, and all you need to access it is a simple understanding of multiplication. Compounding is mathematical alchemy that feeds your savings, accelerating your income without you needing to make any effort at all.

Without it, you’ll likely never reach your financial goals.

Compounding is the mathematical effect that accelerates the growth in your invested savings. It’s the engine that makes it possible to pass the finish line of your financial independence journey.

Knowing what’s under your control

When we invest time and effort in improving our finances, we’re trying to influence two numbers: Our income, and our spending.

That’s it. There’s plenty of complexity when you unwrap those two things, but at its heart, it’s a very simple problem.

When your income is higher than your spending, then the money left over at the end of each month adds to your savings.

As your savings grow each month, you slowly build the pot of gold that will bring you financial independence and security.

If those savings are carefully placed, they grow on their own. Understanding how they grow, and how best to take advantage of that growth, is where compounding comes into the picture.

Where you put your savings

Hopefully, you do not keep your savings in a mattress.

Unfortunately, most “savings” accounts pay such low interest that they’re not really any better than a mattress.

Your savings should be invested somewhere that earns a decent return. What that return is depends on the economic climate and your personal situation and appetite for risk, but it should be above 4%.

The most obvious places to put your savings are government bonds and index trackers. This is because government bonds are almost completely risk-free, and index trackers don’t require you to make judgement calls on the quality of any given company. They’re good places for your money and most non-professional investors opt for a mix of these two investment types for their retirement savings.

When you buy government bonds, you’re basically lending money to the government.

When you buy shares in an index fund, it’s like buying shares in an entire stock market at once. Instead of betting on a single company, you’re betting on the overall performance of every company in that index. So if you buy the Vanguard All-Share Index, the value of your investment will go up and down with the stock market as a whole. This is not risk-free, obviously, but over the last hundred years, it’s earned a lot more than government bonds, despite all the ups and downs.

The math behind compounding

Why is compounding important?

Let’s say that you’ve invested $1000 in an index that returned 5% last year.

You will have earned $50 on that investment. That’s $1000 multiplied by 5 percent.

Add that income back to your total, and your account now has $1050 in it.

If you add another $1000 to your savings at the start of the second year, the balance increases to $2050. 5 percent interest on $2050 is $102.5. Even though you’ve only set aside $2000, you’ve received interest on the extra $50 that you earned in the first year.

$2.50 doesn’t go very far, but that’s only the first year. Keep doing the math for twenty years and the numbers begin to rise faster and faster. It adds up dramatically over time.

What compounding means for financial independence

When calculating your financial independence threshold (the amount you need to retire), you need a few numbers to base your calculations on.

What do I earn? What do I spend to live? What interest do I earn on my savings? What’s my safe withdrawal rate?

The last number is 4%. The reason why is the subject of a whole other post, but as a general rule of thumb, if you can live off 4% of your total capital every year, you’re golden and you can quit your job.

The interest rate is also not entirely up to you. A safe number is 5%. A slightly more aggressive number is 7%. These also are deserving of entire articles to explain them.

How much you earn, and how much you spend. Well, that’s up to you.

If you earn $70,000 and you spend $60,000 then you’re saving $10,000 each year. You can work out what that looks like for yourself, but here’s a little chart:

Here’s a few interesting things about that chart.

By year 15, you’re earning more in interest each year than you’re contributing in savings.

In year 37, your savings are over a million dollars, even though you’ve only actually contributed $370,000. That means you’ve earned over $630,000 in interest. You’re also earning almost $50,000 per year in interest at this point.

In year 41, your interest earnings are above $60,000 for the first time. In year 44 (the first year after the end of the chart), you could withdraw 4% of your capital every year to live off (the withdrawal rate we mentioned above), and that would be more than the $60,000 you need to live.

This is a simple example that doesn’t take inflation into account. A full retirement calculation needs to go into more depth than this. 

Conclusion

What this exercise does show is that if you’re going to retire on your savings, you need compound interest to do the heavy lifting for you. If you let that happen, by saving regularly over time, your money works for you, rather than the other way around. This should be a feature of your financial planning, and the sooner you can start growing your savings, the sooner this effect starts working for you.

I’m no master baker. I’m putting that first because I don’t want you getting the wrong idea.

In fact, I’m not a baker at all.

It’s true that at home we typically cook almost every meal from basic ingredients. That’s a lifestyle habit that predates any attempt to be healthy or save money. It’s just the way my wife and I were brought up.

But bread is one of those things that, for the longest time, I never even imagined I would get anywhere other than a supermarket or a bakery.

And yet now I bake bread for the family two or three times a week. Without a machine to do it for me.

I have no idea how much I save by doing this, because again: It’s not a financially-motivated decision. I’m sure it does save money though. That’s like a perk on top of the fact that we get to eat fresh bread.

Eighteen months ago, give or take a few days, my bicycle was stolen. Very upsetting, and an object lesson in why a decent home contents insurance policy goes a long way, but that’s another story…

Very shortly thereafter we moved home, and the new address was somewhat further away from work than before. This was one of several inconvenient features of our new abode. Also another story.

The question I asked myself was: Now that I don’t have a bicycle (because someone prefers to take from others than to earn for themselves), do I walk to work or take the underground (“subway” for you foreigners out there) to work every day?

I made a decision based on a vague notion that, given the choice, it’s better to not spend money. This is a decision I’ve stuck with for eighteen months, walking 45 minutes each way every single working day.

I also chose to walk because I’m all about taking control of my money, and this is one of those areas that I completely control my spending. If I can’t move the needle here, what chance do you have in areas you don’t directly control?

So I was looking for an idea for something to talk about on my blog today and it occurred to me that I’d never actually run the numbers on this decision, and I’ve spent approximately 450 hours walking as a consequence of this decision. So perhaps I should… you know… check?

It’s quite concerning having to check a decision that’s cost you so much time, facing the very real possibility that you’ve cost yourself several weeks of productive time pounding the pavement just for the sake of getting from A to B and saving a buck or two.

Anyway: How’s that worked out?

One of the basic building blocks of frugality, that I’m sure we all understand, is that little things add up to bigger things. One of these little things that I’ve become good at over the years is doing things myself. Where before I might call someone to fix something, I’m quite likely to get it done on my own now.

This saves money, sure. More than you might think. It also has other advantages.

Repairing things around the house is a small, contant, subtle money leakage. It’s also a frustration and a dependency that you can – to a large extent – manage out of your life.

One day, hopefully soon, you’ll reach that magical moment when you pay off the last of the debt and all the money you’ve been putting towards debt repayment no longer needs to go there. What now?

This is a fairly critical moment. The direction you set is likely to define what happens in your financial life going forward. You are faced with both risks and opportunities.

If you’ve set up the first three parts of the five-step plan appropriately, you should have a clear path to success in front of you.

By now you have

• A monthly budget that allows you to live within your means
• A system for keeping track of your costs, giving you the tools to stick to your budget
• An emergency fund with three months costs saved up, giving you a safety net in case anything should go wrong
• An amount of cash left over after your costs each month, which you will be using to pay down your debt

You now have a long, hopefully fairly straightforward path to being debt-free in front of you. We just need to calculate how long it will take us, and engage a process of continuous optimisation.

By now, if you followed step one and step two, you have a budget that, provided you can stick to it, throws off extra cash every month.

The temptation is to start paying down that horrible debt as fast as possible.

For the long-term success of your plan, however, it’s very, very, very important to build an emergency fund first.

So before you start paying down your debt, build an emergency fund. It will be good for your mental health, for your confidence and the for long-term success of your journey to a debt-free life.

In this step, we’re going to do most of the preparatory work for your journey out of debt. This mostly involves preparing a budget and sticking to it, but we’re going to go into a little more detail than that.

We’re going to do three things.

• Draw up a monthly budget that’s sustainable over the longer term
• Calculate how long it will take to work your way out of debt given the budget you’ve chosen
• Choose the methods you’ll use to track your progress and stick to your budget over the duration of your journey

You should have your minimalist budget that you prepared during the first step nearby as you’ll need to refer to it.

Let’s get started.

You’re at start of a journey, but in many ways you’ve made the most important decision. You’ve decided to do something about it. In this first step we’re going to build a minimalist budget that exposes the hard inner core of our most unavoidable expenses.

You’re at the point of maximum frustration. You’ve tried a few things but realise that you need a more organised, comprehensive approach. You’ve finally decided that you have to do something about your debt situation.

But where to start?

There’s only a certain amount of effort and energy you can dedicate to a task. As you probably know from bitter experience, if you don’t put your effort in the right places, and you don’t see some results, you’ll get discouraged and it will become impossible to continue.

Flicking through websites, we find many people who claim to have paid off staggering amounts of debt in record time. They make it seem almost too easy. Just download their printable and you’re home free, right? But you already know that’s not how it works.

You can’t transform a difficult debt situation into a debt-free life at the flick of a switch, or by applying a simple “life hack”. It’s going to take time, effort and a plan. The plan focuses your effort where it has the most effect and helps measure progress towards your goal.

Before you leap, take a step back. Take control of the smallest and easiest and most essential thing of all: Your day-to-day essentials. Draw up a minimalist budget of your most essential costs. This will give you an idea of what it’s possible for you to save each month.

This article explains how.

A goal without a plan is just a wish.

Antoine de Saint Exupéry

Do you wish you could eliminate your debt, create some financial security and find the right approach to regain control of your finances?

The bad news is that wishing isn’t enough.

The good news is that if you’re reading this, you’ve already figured that out for yourself and you’re ready to move on to something more effective.

What you need is a plan.

A plan provides structure, objectives, step-by-step initiatives you can follow and milestones that you can use to keep yourself motivated.

Without a plan, what you have are a jumble of tips, hacks, tricks and ideas that, while each useful in it’s own small way, don’t add up to much without some kind of framework or plan to organise them.

I’m going to present a plan that you can follow to identify the steps you need to conver your costs, repay your debt, understand your finances and take control of your financial life.

What percentage of the time do you use your car? How much of the time does it sit, empty and alone? Cars cost money to own and spend most of their time idle. You probably don’t need one.

Once you have a car, it’s difficult to imagine life without one. It becomes a part of a great many rituals and we build a life around the availability of the car for weekends, holidays, grocery runs and everything else in-between.

The car is, however, a huge money drain. It costs a fortune to own, to run and to insure. In this article I’m going to cover

• How much your car costs you
• The alternative modes of transport you could use
• What it’s like to live without a car
• How to switch to carless without losing your mind

I posted a few weeks ago with a savings plan calculator that allowed you to build you own 52-week savings plan using a google spreadsheet that I shared.

I thought about that some more and wanted to make it more versatile. What if you want to save over only 40 weeks, for example? What if you wanted to start with savings of £20 per week?

Check out this article to see the free online savings plan builder that achieves whatever target you choose.