Compound Interest, Or Why You Should Start Investing Now

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.

Uh-oh.

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.

Continue reading “Compound Interest, Or Why You Should Start Investing Now”

Smart Ways To Spend A Windfall

They happen every now and then, and they’re oh so fun when they do. Tax refunds. Gambling winnings. Inheritance payouts from a relative’s will. Monetary gifts. If you have escrow on your mortgage, excess from your escrow. These items are referred to as windfall income, a one-time infusion of money from various sources. You can’t count on it happening again, but it’s often in large amounts.

Large or small, it’s very tempting to run right out on a clothes shopping spree or go get that new phone you’ve been eyeing. There are so many things to spend money on, aren’t there? And so many retailers are holding great sales right around tax time.

Not so fast, is my advice.

Especially around tax time, retailers know perfectly well that the majority of Americans get refunds on their income taxes, and their goal is to get you to spend it at their store. The timing of these sales is absolutely not by accident, and the majority of these retailers are selling you things that are nice to have, not things that you really need. Consumerism is rampant in American society, and feeling flush with cash can make it hard not to fall for the carefully-tailored psychological ploys designed to get you to leave it with your favorite store.

Before you and your cash-infused friends hit the mall, consider these other ways to spend your money.

Create (Or Add To) A Rainy-Day Fund

A rainy-day fund is a key part of any responsible and well-managed financial plan. It covers things like an emergency auto repair, dental work, or your bills in the event of a job loss. It keeps you from having to run up your credit cards to handle the budget-busting emergency expenses that are part of life, and keeps you from having a debt-reduction plan derailed by an emergency expense.

This fund should not be confused with savings for planned expenses such as weddings, vacations, car down payments, and so forth. That should be a separate account from this fund.

How much should be in it? That depends on your life situation and your income. Experts recommend starting with a goal of $1000, which is generally enough to cover dental work or many car repairs. My experience says that serious dental work ends up being $1500 or more, so I recommend working up from there. In a perfect world, you’ll have three to six months’ worth of living expenses saved up against a job loss, but that goal takes time to attain.

Start somewhere. If you don’t have a fund at all, open a new savings account with your current bank and start one. If you use the three-account system I mentioned last week, open it at the same institution as your bills account. If you do already have one, consider designating a percentage of your windfall to adding to it.

Invest It

An investment is basically using your money to make more money. It takes a lot of time to build up a lot, but patience and discipline pays off.

Have you started saving for retirement? If not, I recommend getting started. The longer a small amount of money has to grow, the more it becomes. Even if you can’t contribute a lot, contribute something, and give that little something more time to weather the ups and downs of the stock market and become a big something.

If your employer does not offer 401(k) pre-tax retirement contributions, you can still invest post-tax for retirement by contributing to a Roth IRA. You can also invest money for medium-term goals, like a down payment on a house, college savings for a child, or paying for your wedding. There are even mobile apps that allow you to invest small amounts at a time, such as Acorns, Betterment, Robinhood, and Stash.

Pay Off Debt

Got student loans or a car loan? Most loans today allow you to pre-pay all or part of the loan without penalty. Check to be sure that this applies to your loan before you do it, but consider paying off part of that loan. If you pay more now, you’ll end up paying less in interest later because of the way loan amortization works.

How about a credit card? Is it maxed out? If you owe on a credit card, you already spent that money in your hand. Paying off that credit card will help you avoid finance charges and late fees, and a whole lot of worry and headaches.

Take Care Of A Problem

I did this with my tax refund this year. I spent most of it to address a non-working toilet, a non-working sump pump, and some other plumbing problems in my home, and I consider it money well spent. Fix your car. Get it cleaned/detailed. Address any standing problems in your home. Get new glasses. Have your teeth fixed.

Save For A Goal

A down payment on a car. That road trip. A cruise to the Caribbean. That 60″ TV. These are all things that take time and money to work towards, but not usually so long that it’s worth taking the risk of investing it. Shoving some money in a savings account is never a bad idea.

Deal With Taxation

Be aware that some windfalls, particularly inheritances and gambling winnings, may be subject to taxation in your place of residence. If so, consider setting some of it aside to cover that.

A Final Word

None of this is to say that having a little mad money is a bad thing. It’s not. I’m not suggesting that you devote every dime you got to the boring adult stuff. A responsible adult, though, will not blow all of a windfall on fun. They’ll take care of business first and leave a little on the side for fun, instead.