Money

Is compound interest your friend or enemy? Ally or adversary?

“Compound interest is the Eighth Wonder of the World. He who understands it earns it; he who doesn’t, pays it.”

This quote is attributed to Albert Einstein, even though it’s not a slam dunk he actually said it. But the point is valid. Compound interest can either be your friend or enemy.

Here’s what it looks like when compound interest is your enemy:

Let’s imagine you buy a TV for $1000 using a credit card that has a 24% interest rate. Then let’s assume you don’t buy anything else with that credit card, so now you’ve got a balance of $1000. Based on the 24% interest, you’ll be charged $240 in interest over twelve months or $20 per month.

Now let’s see how compound interest becomes your enemy. When it’s time to pay back the $1000 plus interest, you realize the credit card company is not your friend so they will get their money first. That means when you make your minimum payment (most cards define this as 1% of the balance plus the monthly interest due on the balance), the majority of that money goes towards the interest.

That means every single month you’ll pay close to $20 in interest, but your total balance is reduced by less than $10. This means if you only paid the minimum payment, it would take 125 months to pay it off and you would pay $1,332 in interest. Remember the tv only cost $1000!

That’s how compound interest is your enemy. Now let’s see how it can be your friend.

You’ve probably heard this example because it works. I’ll give you 2 choices. The first is I’ll give you a million dollars and you can walk away. Choice number 2 is I’ll give you a penny today, then double the amount every day for 30 days. What would you choose? A lot of people would take the million but that would be a mistake. Like a $3 million dollar mistake. Because if you took choice number 2, you’d have over $4 million dollars at the end of 30 days

Ok, it’s tough to find an investment that doubles every day so let’s look at a more realistic scenario.

Let’s say you saved $1000 a year from age 25 to 34 in an investment account earning 8% a year and not a penny more. Your $10,000 investment would be worth $157,435 by the time you were 65.

Now let’s say you don’t start saving $1,000 a year until you’re 35. But you do it for 30 years for a total investment of $30,000. Even though you invested $20,000 more you’d only have $122,346 by age 64. $35,000 less!

That’s how powerful giving your friend Mr. Compound Interest lots of time to work can be.

So now you see the importance of making compound interest your friend. But how? Three steps

1. Pay cash for everything
2. Pay yourself first every time you get paid
3. Have $2,000 in cash you can put your hands quickly

This puts you in a place where you can put Mr. Compound Interest to work for you instead of letting him take your money.