Compound Interest: the Great and the Terrible
Disclaimer: I am not in anyway legally qualified to give anyone financial advice!! DO NOT do something just because I said it sounded like a good idea. Open your mind to my thoughts, take it to a professional advisor or someone else you trust, and only then make your decisions.
Welcome to the third post of the Financial Keys series! A few weeks ago I talked about the different components of debt and today I want to elaborate on one of them, interest! More specifically, I want to talk about what happens when interest compounds. There will be a lot of numbers in this post, but stay calm and stay with me! Here's why you should read this post all the way to the end:
Compound interest is a very powerful financial tool and I want you to understand it and be able to use its power for good in your life!
First of all, it's important to understand that interest has one job and that is to pay the lender for the opportunity to borrow the money. Sometimes that's good because you're the lender, sometimes it's not so good because you're the borrower... You can look back at my last post for a more in depth look at how interest works.
This week, I want to focus on the super powers of compound interest, for good and for bad, and how you can put yourself on compound interest's good side. I always like to hear bad news first so we'll start there.
BAD COMPOUND INTEREST
Do you remember me talking about "bad debt"? This is where the story begins... let's say I go shopping and spend a $1,000 that I don't have by putting it all on a credit card. The Credit Card Company lends me that money for a fee, a 15% Annual Percentage Rate (APR). An interesting thing about credit card interest is that it is usually compounded daily, which means that the 15% APR is divided by 365 days, and each day the credit card company will charge me 0.041% of my balance in interest. So after the first day my balance becomes $1,000.41 and the next day they will charge me 0.041% of the new balance. I know it doesn't seem like much, but it really adds up over time. Especially if I'm only making the minimum payment. Especially if I didn't have the money in the first place...
Let's say I continue making my minimum payment. It would take me an estimated 12 years to payoff, aaaand I would pay $2,163... That's more than twice the amount that I originally spent.
And that's just a $1,000 balance. Just imagine if I had kept using the card and piled up more debt! This is the power of compound interest working against me. The higher the interest rate... the quicker the monster grows.
GOOD COMPOUND INTEREST
Now let's change the story: I don't go shopping, I live modestly and manage to save $100 a month. At the end of the year, I put that $1,200 in a retirement account that earns an average of 7% per year, because in this story I'm smart :)
Compound interest is so powerful because each period the new balance of the loan is considered. This means that each year my retirement account will grow and I'll add an additional $1,200 and the new growth is estimated to be 7% of all that put together. That's why the magic of compound interest comes over time.
If I continued making the $1,200 yearly payments until I was 65... My account balance could reach $318,145! (All for contributing a total of $51,600 over the years, which means my money would have made me $255,155!)
If I could manage to save enough to max out my contribution limits, it is very possible that I could retire with millions in my accounts. This is the power of compound interest working for me. The higher the rate of return and the more money I save over the years... the more I can spend on myself during retirement and the earlier I can retire!
Amazing, isn't it? By putting money in the right places (assets) and keeping money out of the wrong places (bad debt), your money can work for you in powerful ways. Once you understand where to put your money, you need to understand when to put it there.
The answer: NOW. Or as ASAP as possible. (An Office reference in case any of you love the office as much as I do!)
By waiting just 5 years to start the payments of $1,200, my account balance would shrink to $221,568 ...which isn't bad, but that's close to a $100,000 difference.
It's also important to realize that the more you can build up your principle (the amount of money you actually contribute to the account) in the beginning, the more powerful compound interest can be for you. My example of just $1,200 a year is baby talk compared to some bigger payments. All retirement accounts have different contribution limits, but I strongly encourage you to talk to your employer about work sponsored accounts (many times employers will match what you put in, don't miss that opportunity for free money!) and find a financial advisor that can help you set up an individual account so you can start taking advantage of the time your money can work for you.
In summary, time and money are scarce. Those of us just getting started on our financial journey need to be wise about our financial decisions so we can make the most of our money and our time by letting our money work for us! I hope this week's post encourages you to take action NOW and keep your money on compound interest's good side.
May the power be with you!