Compound Interest. Even typing those words used to bore me. That’s no longer the case for me and, after reading this, I hope it won’t be for you as it has the power to transform your financial future. Be like this guy. Harness your inner kid positivity and read on:)
Just what is Compound Interest?
Compound Interest is a mathematical rule that over time means you either pay much more for the money your borrow (credit) or it earns you much more for investments/savings. For borrowing, you pay interest not only on the initial amount but, the interest applied in previous weeks/months/years. The longer the loan, the worse it is for your financial health.
For saving, it’s a positive flip where you earn interest on both the money you’ve saved and the interest you earn. To help understand what this means in the real world, let’s work through three common examples.
Say ‘Hi’ to Dan. Dan has worked hard all year and wants to spend a week vacationing in the entertainment capital of the US, Las Vegas. Dan is smart. He uses price comparison websites to get cheap return flights to Las Vegas and scores an online deal to stay at a swanky hotel. After a week partying, flights, accommodation, and entertainment have put a $3K sized dent on his credit card. Although Dan avoided ‘the house’ winning too much, is Dan still smart?
In short, it depends on his credit card management skills. Assuming an interest rate of 15%, if ‘Responsible Dan’ demolishes his credit card debt by paying $500 off each month, he’ll be debt free in under seven months and only have paid $138.53 in interest. Go Dan, you didn’t allow Las Vegas or compound interest to harm your wallet too much!
However, if ‘Frivolous Dan’ pays just his 2% minimum credit card payment each month, it will take him 264 months (22 years!) to finally clear the debt. For his original $3000, he will have paid (and this is astonishing), $4,184.52 in interest payments on top of that. That is the power of compound interest working against you. And we wonder how the bankers keep getting richer!
Meet Jane. Jane wants to own her own car and has a credit rating to allow her to get a car loan. After hours of haggling, she agrees to buy the car of her dreams and is so happy, she’s balancing precariously out of her car below. Should she be happy? How will compound interest affect her bank balance in the future?
Sorry, couldn’t help myself but this was a trick question! Thankfully, car loans don’t compound – you only pay a % of the loan amount. Let’s say Jane took out a loan of $20K at a loan rate of 4.5%. To keep her monthly payments down, her loan is for 5 years. She would pay $373 dollars each month. Not too bad, but over the 5 years, she will shell out $2,372 in interest charges.
Jane’s cheer is, therefore, fitting but would be more so if she gave a bigger deposit or reduced the length of the loan. Reducing the loan length to 30 months reduces interest paid to $1,184. That $1188 saved would buy Jane a lot of furry dice.
Jen and Darryl are next up. Even though they are in their 20’s, they are already thinking ahead to retirement and guess they may need more than their work pensions to live comfortably from. Question is, should they start early, wait until their 30’s or even their 40’s? The key thing about compound interest is that time is incredibly important. Consider the following chart for an investment value of $300 per month:
As you can see, starting as early as 25 (with a realistic return rate of 5%) will net close to half a million by 65. The same couple starting 10 years later would get back just over $250K. Starting later still (at 45), even upping payments to $600 each month gets nowhere near the early starters!
I hope you’ve found the above eye opening and can now see why a little-known guy called Albert Einstein said the following: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Please comment below and remember to keep checking in with Wealth-Hack. Our goal is to build on Einstein’s 8th wonder and create advice that will help you overcome your finances and live a more rewarding life.