Compound interest. The 8th wonder of the world.
Do you know the power of compound interest in its entirety?
It’s the greatest thing in the world…when it’s working for you.
When it’s working against you, it can be one of the most devastating things in the world. A catastrophe, really.
I’m just going to take a minute or two to show you the amazing power of compound interest. Then I’ll let you decide if you would rather it work for you or against you.
Here it is. Compound interest. The good and the bad…
Why Compound Interest is Powerful
Compound interest may be more powerful than you think. If you don’t understand exactly how it works, it’s helpful to figure it out. And you came to the right place, because I’m about to explain how it works…both for you and against you.
According to some recent polls, most Americans don’t actually understand how compound interest works.
Many people think that if you have $100,000 and you get a 6% annual return, compounded over 30 years, you’re left with…$106,000. Not quite. It would actually be over half a million dollars. Crazy, right? That’s compound interest for you.
So what happens exactly?
Interest generally compounds annually, so that means you earn 6% on your principle. Keeping with the above example, the first year your principle is $100,000, but at the end of that year, you earn 6%. So that means the second year you’ll be earning 6% on $106,000. Making sense yet?
Of course, this is an oversimplified example and it’s next to impossible to find a 6% return on your investment that stays at exactly 6% for 30 years, but it does make it a whole lot easier to explain. Got the idea?
Here are a few ways compound interest can be your best friend:
- Investing – Just like in the above example, compound interest, over time, can lead to extraordinary results. You continue to earn interest on your money and it continues to grow as it compounds. That’s why a one-time contribution of $100,000 could easily grow to several times that over your life span.
- Early Debt Reduction – I’m about to explain how compound interest can be your worst enemy when you’re in debt, but you can actually take advantage of it with your debt too! By paying extra on your loans, early-on in the term, you will reduce your interest bill by a ton. In fact, with your mortgage, making a few extra payments in the beginning can knock years off the length of the loan. Don’t believe me? Read this.
If you prefer more of a mathematical explanation, here is the formula, with a worked example:
The formula for annual compound interest is A = P (1 + r/n) ^ nt:
A = the future value of the investment/loan, including interest
P = the principal investment amount (the initial deposit or loan amount)
r = the annual interest rate (decimal)
n = the number of times that interest is compounded per year
t = the number of years the money is invested or borrowed for
If an amount of $5,000 is deposited into a savings account at an annual interest rate of 5%, compounded monthly, the value of the investment after 10 years can be calculated as follows…
P = 5000. r = 5/100 = 0.05 (decimal). n = 12. t = 10.
If we plug those figures into the formula, we get:
A = 5000 (1 + 0.05 / 12) ^ 12(10) = 8235.05.
So, the investment balance after 10 years is $8,235.05.
You may have seen some examples giving a formula of A = P ( 1+r ) ^ t . This simplified formula assumes that interest is compounded once per period, rather than multiple times per period.
Compound Interest as an Enemy
Just like compound interest works for you, it can work against you (which means it’s work for somebody else).
When you’re investing, it’s nice to know that you’re interest compounds annually, when you’re in debt, it’s terrible to know that your interest compounds annually. This means that you pay your APR (Annual Percentage Rate) every year, based on the remaining balance. So if you owe $10,000 on your car and you have a 14% interest rate, you pay 14% of $10,000 the first year. After that you pay 14% of the remaining balance each year. Of course that amount is divided over your monthly payments.
This is why, if you have ever looked at your mortgage annuitization schedule, you may have noticed that during the first few years, the majority of your payment is going to interest. That’s terrible if you’re paying your regular minimum payment, but if you pay extra, you can take a huge chunk out during the early years.
Here are a few ways compound interest can be your worst enemy:
- Mortgage – The typical mortgage in the United States is 30 years! That means that even a low interest rate of 2% or 3% can be well over $100,000 paid in interest over a 30 year note.
- Consumer Debt – Credit cards and auto loans are the two most popular forms of consumer debt and two of the most likely to have a high interest rate. The higher the interest rate, the more each percentage matters. In other words, there is a bigger difference between 14% and 15% than there is between 2% and 3%. So those crazy-high interest rates could mean that you’re actually paying more in interest than you are in principle.
The Line Between Investing and Paying Off Debt
I wrote an article about the “pay off your mortgage or invest the money?” debate and I actually proposed a compromise between the two, but the debate is real. Many people think it’s not worth your time to pay off your mortgage early since you can get a better return by investing the money. In other words, you can earn more by investing than you would save by paying off your mortgage early. Obviously this depends on both interest rates.
So where is the line between paying off debt and investing the money?
It’s definitely a blurry line. There’s no magic number, but when you can consistently earn more by investing than you save by paying off your debt, it’s at least worth considering. Just make sure you account for any taxes you may have to pay on capital gains if your investing in a taxable account.
And here’s a general rule: when it comes to high-interest consumer debt, pay it off before you start investing heavily for retirement. Feel free to have your emergency fund in place and contribute enough to your employer’s retirement fund to get the match (if they offer a match), but other than that, the debt comes first.
It simply doesn’t make sense to be earning 7% or 8%, while your paying 20% on your credit card’s revolving debt. The debt must go.
Remember the power of compound interest and make sure it’s working for you, not against you. 🙂
Have you had more good or bad experience with compound interest? Share in the comments!
Photo Credit: Gratisography
Formula: The Calculator Site
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