When I was in college (way back), I got my first credit card. At first, I kept it paid off. But slowly, I started spending more than I was paying off. I was still making more than the minimum payments, but a balance was accumulating. A couple of major car repairs, and I was deep in over my head. I was paying more than the minimum, but less than the interest. I was learning the first lesson of too much debt: compound interest is not my friend. Once I started paying interest on interest, I was in trouble. By the time I realized I was in trouble, I was overwhelmed and in collections.
Compounding is a relatively simple idea. Go to a compound interest calculator, like this one at investor.gov, so we can play with numbers. Say you have $10,000 and a 4% annual interest rate. At the end of one year, with simple interest I would have $10,000 X 1.04, or $10,400. But say the interest is compounded monthly. To do this, I do the same calculation, but then divide the interest rate by 12. Once I have that total, I take the $1003.33, and multiply it times 1.04/12. I do this 10 more times, and reach a total of $10,407.42. I have an additional $7.42 from compound interest. Ok, that’s enough for a fast food meal. Now let’s add some more time. In 10 years, we have a $908.33 difference between simple and compound interest. In 20 years, the difference is $4225.85. In 30 years, $11,134.98. In 40 years, we have amassed a total of $16,000 with simple interest but $49,398.71 with compound interest.
Now plop in an interest rate of 17.99%. That’s a not uncommon rate for credit cards. Punch in $1000, and let’s go back to 1 year. It’s a $15.60 difference. At 5 years, a $542.52 difference. At 10 years, we have a $3164.44 difference. $3164.44 is over 3 times the starting amount of $1000. And that explains why compounding interest got me into trouble. Okay, I paid off my debt in less than 10 years, but it was a bit more than $1000. The point is that by the time I was paying down the debt, i was paying interest on interest on interest.
I had taken Econ 101. Unfortunately, I skipped right over the concept of compounding until I tripped over it. It’s important to understand, though, because whether you are getting into debt or investing for the future, compounding is going to determine how much money you are talking about.
It took years of constant digging to get out of the debt hole I had dug. Not only did it take a while to pay off the debt, but I had to live with poor credit until it was old news, then rebuild from scratch. Thankfully, I was living with my mom, and could work on paying off credit card and student loan debt. I could even start investing. And now we come into the part where compounding can be your friend, because your investments can compound over time just like your debt does. Under the right circumstances, compound interest is your friend.
Let’s go back to our calculator. This time, let’s set our initial principal to $100, but add a monthly addition of $50, and set the interest rate at a modest 5%, compounding monthly. At the 1 year mark, with a total investment of $700, we’re looking at $719.06. By the end of our 40 year period, we have $77,036.85 for our investment of $24,100.
And if we put all $24,100 to work at the beginning, and never add to it? We end up with $177,337.86 at the end of 40 years, or an additional $100,000 over the incremental plan. The additional money at the beginning had more time to work, which led to a lot more money in the end.
Compound Interest Takeaways:
Debt is problematic when you don’t pay your interest. I’ve had it knock me on my derriere, but managed to crawl out and stand on two feet. I’ve heard horror stories of people who let debt (especially student loans) balloon due to compounding interest. If you do get in debt, make sure you are paying down principal, not just part of the interest. If you are deferring payments, at least cover the interest. Compound interest is an enemy you can defeat.
When investing, compound interest is your friend. Longer time horizons are better than shorter. So is putting money to work early, but a slow and steady trickle grows over time. You have to remember that the way compound interest works, your gains at the end are much bigger than at the beginning. This is important, as a recent study on retirement savings showed that only 22% of Americans understand that savings grow exponentially, not linearly. It’s easy to get frustrated and discouraged when you begin saving, because it takes time for your investments to grow. You have to have a plan and an awareness of compound interest to make sure you are on track with your savings.
Is compound interest your enemy? Have you made friends with compounding? Which is a bigger concern?