This is one of those things that a financial adviser tried to tell me at 25, and he was right.
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
— Albert Einstein
Interest — the fee that is paid for the use of money — is a concept that most adults are familiar with. If you put your money in the bank at 3% interest, that means that the bank will pay you 3¢ for every dollar of yours in the bank, because they use that money for other purposes and track how much they owe you. The reverse is also the case – if you borrow money at 10% interest, for every dollar you borrow, you pay back a dollar and a dime.
That’s simple interest. Compound interest earns you more money still. Consider that bank account that earns 3% interest again, except that this time, it’s compounded quarterly. Every three months, the bank looks at how much you have in that account and deposits 3¢ for every dollar in there. Say you start with $100 in that account. Instead of paying you $3 directly in interest, they’ll put it in the account. Leave it in there for three months, and they’ll pay you 3¢ on the dollar on $103 instead, and you’ll have $106.09. Another three months with no change, and that becomes $109.27.
The reverse is also the case, if you borrow money. If you put $100 on a credit card at 10% interest, your minimum monthly payment might only be 2-3% of the balance. Let’s say we pay a minimum payment at 3% of the balance. The first month, you pay $3, but the interest is 10%. So interest is actually 10% of $97, or $9.70, and that gets added to the total amount you owe. Next month, you’ll owe $106.70.
I paid on it, but the balance went up?! That’s right. Compounding interest can make your balance go up, not down, if you only make minimum payments. That’s why you should always pay enough on any revolving debt to pay all of that month’s interest AND some of the principal. Doing so is the only way you can keep your balance going in the right direction. For installment loans, this math is already done for you in a process called amortization, and the interest on the loan is included in your calculated monthly payment. Credit cards don’t do that, though, and minimum payments can get you into real trouble as in the example above.
As an extreme example of the power of compounding, consider this question. Which would you rather have, a million dollars or a penny doubled daily for 30 days? Go do the math, I’ll wait. (The answer is under the cut tag at the bottom of this post.)
Here’s the trick — making that happen takes time. The more time you have, the more money you get. So, even if you have to start with $5 a week or $5 a month, the earlier you can start, the more time that money has to make more money for you.
The second reality is that banks don’t pay 3% interest. Most of them don’t even pay 1%. It’s garbage, really, because inflation typically runs 2-3% per year. If your money isn’t earning that much, you’re losing value over time. The deal a bank gives you for the use of your money is really crappy. For that reason, I recommend investing any money that you’re putting aside for two years or more – not just retirement, but things like college savings or a down payment on a house or a wedding. That money you put aside earns more money for you while you wait.
But can’t I lose it all in the stock market? you ask. Good question, and the answer is yes, you can, but you have to make some pretty serious investing mistakes for that to be likely over the long haul. I’ll talk about that in Monday’s post.