Compound Interest and How It Can Help or Hurt You
Shownotes
You’ve probably heard people talk about compound interest since you were in high school--remember the A = P(1 + r/n)^nt formula you had to memorize for your 9th grade algebra class?
That’s because compound interest is a powerful tool that can either really help or really hurt you and your personal finances.
And, yes, this IS one of those concepts that most of us are introduced to at some point in high school (like in Algebra 1), BUT we learn it so early in life that the importance of compounding interest doesn’t really settle in at all, because we don’t have the lived experiences to back it up.
What is compound interest?
In a nutshell, compound interest is when accumulated interest is added to the principal balance... or when interest is added on top of interest.
This is different from simple interest, which is when your interest expense is a percentage of your principal balance. Compound interest is when your interest expense is a percentage of your principal balance and all previously accumulated interest.
When interest is lumped into our principal balance, we can start to see an exponential increase in the balance overall.
The most important factors that contribute to compounding interest are:
Principal balance
Interest rate
The number of times the interest compounds each year
Time
And when we’re talking about the number of times that interest compounds each year, it can be annually, monthly, or even daily. The more frequently compounding happens in your account, the more interest you generate.
And, depending on these factors, compound interest can be used in your financial life to help you build wealth faster, OR it can be used against you to keep you in debt longer.
How Compound Interest Can Help You
Let’s say that we put $2,000 into a high yield savings account that compounds annually for 3 years with a 0.5% interest rate and you made no other transfers or withdrawals into that account.
In 3 years, that account would have $2,030.22 cents, but you would have only put $2,000 into that account–meaning that $30.22 came from compound interest (without you doing any extra work!)
Now, if we keep the money in that account for another 2 years on top of that, that extra $30.22 is added to the principal balance. So you’re earning interest on the $2000 you saved AND the $30.22 you’ve earned in interest as well.
And, 2 years later, that account will have $2,050.62 cents without you doing anything!
But, you’re probably thinking something like “a 0.5% interest rate in a savings account? That’s nothing!!” So, let’s talk about what this the same $2,000 could look like when invested.
Compound Interest & Investing
Let’s say someone wanted to use $2,000 and invest it in the stock market for a long term financial goal. So they invest that $2,000 in a diversified investment portfolio with an 6% annual rate of return that compounds monthly and they don’t touch it for 20 years.
After 3 years, the future value would be $2,393.26, after 5 years, it would be $2,697.70, and after 20 years, it would be $6,620.41!! Meaning that $4,620.41 would have accumulated in interest without this person doing ANYTHING after that initial investment.
That’s pretty cool!!
Now, with compound interest, you want to keep in mind that the higher the principal balance, the higher the interest rate and the longer the period of time, the more money that will be accumulated.
The sooner you start saving or investing money and the more you contribute, the more money you will have in the long run.
That’s why personal finance experts recommend individuals start saving for retirement as early as possible, so that they can have as many compounding periods as possible.
Let’s take a look at an example of why that is:
Let’s say that three hypothetical women each have $500 to invest and continue to invest another $500 per month for 10 years, and they each have an 8% annual rate of return on their investments, compounded monthly. After that 10 years, they each decide to STOP contributing to that investment until they reach the age 65.
Each hypothetical woman would have invested a total of $60,500 over the course of 10 years with the exact same annual rate of return, the only difference is which decade of their life they invested.
Maya: 25-35
Natalie: 35-45
Grace: 45-55
After those 10 years, each hypothetical woman has a total of $92,582.84 (again, remember that they have ONLY contributed $60,500 of their own money–the rest is compound interest)
And now that $92,582.84 is going to hang out there until each hypothetical woman reaches the age of 65. So let’s see how the additional years for that money has to compound impacts the final number at 65 years of age.
Maya was 35 after the 10 years and had an additional 30 year for the money to compound: $1,012,460.91
Natalie was 45 after the 10 years and had an additional 20 years for the money to compound: $456,137.39
Grace was 55 after the 10 years and had an additional 10 years for the money to compound: $205,500.60
EACH WOMEN invested the same amount of money, with the same annual rate of return, with the same compounding frequency, but Maya is retiring with $806,960.31 MORE than Grace, simply because there was more time for the money to compound.
Albert Einstein called compound interest the 8th wonder of the world, and for good reason.
As a general rule of thumb, if your investments return 6% annually, your investments will be able to double around every 12 years.
That’s wild!!
And, not only can time be beneficial in increasing the rewards of your investments because money have more time to compound, it can also help lower your investment risk as well:
Time and Investment Risk
According to data compiled by Vanguard from the Standard & Poor’s 90, the S&P 500 Index, the Wilshire 5000 Index, the MSCI US Broad Market Index, and the CRSP US Total Market Index, based on historical data, if you invested in the stock market for 1 year, your chance of losing money would be more than 1:4. If you invested for 10 years, that number drops to 1 in 25– and after 20 years, that number drops to 0!!
Of course, all investing is subject to risk (and even diversification can’t guarantee a profit or protection against loss), including the potential to lose the money invested, AND past performance does not guarantee future returns, but it’s important to look to that past data to make an informed decision for your finances going forward.
How Compound Interest Can Hurt You
So, now let’s talk about how compound interest can HURT you, because we’ve seen how big of an impact compound interest has on wealth building already, now it’s time to talk about what can happen if you are being CHARGED compound interest (like for a credit card balance), which means your debt can grow just as fast as well.
If you have a debt balance with a high interest rate, compound interest is working against you.
Let’s say you have a $6,194 credit card balance with an average interest rate of about 17%. Which, according to CNBC, is the average credit card balance and interest rate for Americans (the average credit card interest rate is actually 16.97%, but I’m rounding up for the sake of this example)
If your minimum payment is calculated by 3% of your total balance, the minimum payment would be $185.82 per month. At this rate, it would take 204 months, or 17 YEARS, to pay off that debt!! And by the end of those 17 years, you would have paid an extra $5,276.08 in interest.
Yikes.
This is why so many financial experts recommend the Debt Avalanche Method as a debt repayment strategy.
The Debt Avalanche prioritizes paying off debts in the order of highest interest, which makes the most mathematical sense, especially if you have high interest debt like credit card debt. If you pay off debts with the highest interest rates first, you will likely save more money on interest in the long run.
I ALSO think this example really paints a picture of how a minimum payment really ISN’T the minimum amount you should pay towards your credit cards each month. If you only pay the bare minimum you’re contractually obligated to pay to your credit card each month, you are really setting yourself up to lose a LOT of money in interest in the long run.
Closing Thoughts
Everything we’ve talked about today shows how compound interest can be used to help us build wealth faster or stay in debt longer.
Understanding the effects of compounding interest is so important when it comes to managing your personal finances--the better you understand it, the better you can use it to your advantage!
And if you want to use compound interest in your favor, the key is to give yourself as much time as possible to build wealth–so you have more TIME for your money to compound and grow!
This means, avoiding situations where compound interest works against you (in other words, avoiding high interest debt and paying it off asap), and consistently investing early so your money can work FOR you.
That’s all I have for you today! I hope this podcast episode was super helpful and informative for you. If you’re interested in checking out the calculators that I used for these examples, I’ve linked them and the explanations in the for you.
Finally, I want to give a quick disclaimer that the content and information provided on this podcast is for educational purposes only and does not constitute professional financial, investment, accounting, legal, or tax advice. For recommendations on your specific financial situation, you must additionally seek the services of an appropriate licensed legal, accounting, tax, or investment professional.
Calculators (and how I calculated the examples in this episode)
Bankrate Credit Card Calculator
Credit Card Balance: $6,194
Interest Rate: 17%
How minimum payment is calculated: 3% of balance
Investor.gov Compound Interest Calculator
First, I calculated the first 10 years of the three hypothetical women's investment:
Initial Investment: $500
Monthly Contribution: $500
Length of time in years: 10
Estimated Interest Rate: 8%
Interest rate variance range: 2%
Compound Frequency: Monthly
Then, I took the final age that each hypothetical woman made their last investment, and subtracted it from the age of 65 to see the impact that time would have on the $92,582.84 they would have based on the calculation above.
To do this, my inputs into the calculator looked like this:
Initial Investment: $92,582.84
Monthly Contribution: $0
Length of time in years: 65 minus the hypothetical woman stopped contributing to the investment
Estimated Interest Rate: 8%
Interest rate variance range: 2%
Compound Frequency: Monthly
Sources
CNBC - Average Credit Card Balance By State
The Ascent - How Does Compound Interest Work?
Vanguard - How risk, reward & time are related
Disclaimer: The content and information provided on this podcast is for educational purposes only and does not constitute professional financial, legal, or tax advice. For recommendations on your specific financial situation, you must additionally seek the services of an appropriate licensed legal, accounting, tax, or investment professional.
Music written by Chris Glassman