Forget about the Grand Canyon, Eiffel Tower, or Taj Mahal, they don’t come close to approaching the true eighth wonder of the world. I’m referring to “compound interest”.
But don’t take my word for it, read this quote by “another” (ha ha) mathematical genius.
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Good quotes
Those words were uttered by the great mathematician, Albert Einstein. If you can’t heed his advice, I don’t know if you’re a worthy ninja for this dojo.
Anyway, in a moment I’ll explain what compound interest is, and how it can quickly grow or destroy wealth. But first I want you to get an idea of the types of investments and expenditures that are affected by compounding and compound interest. Check out these familiar items:
– Credit Cards
– Mortgage Loans
– Saving Accounts
– Certificates of Deposit (CDs)
– Mutual Funds
Okay, that should be enough to make it clear that compound interest plays a big role in all of our financial lives. Now let’s get to the nitty gritty.
What Is Compound Interest?
It is the interest that is calculated on the outstanding principal plus the cumulative interest amounts from prior time periods. I’ll give you an example shortly.
But for comparison sake, and just so you’ll have an appreciation for compound interest, I want to quickly explain another popular type of interest called “simple interest”. Just as there are plenty of investments that pay compounded interest, there are some that pay simple interest.
If you have an investment or savings account that pays simple interest, then you will only earn interest on the outstanding principal amount.
For example, let’s say that you put $1,000 into a Certificate of Deposit that pays you a simple interest rate of 10% annually for 3 years. This means at the end of each year you’d receive a payment of $100 ($1,000 x .10) in interest. So, by the end of three years, you would have made $300 on your investment. The math is pretty…ummmm…simple, right?
Of course, compound interest isn’t that straightforward. That’s because of a magical feature where interest is also paid on the interest amounts you’ve already earned. I’ll give you the formula for calculating compound interest and then clarify it’s meaning.
Here’s the formula:
M = P( 1 + i )n
M = final total that includes the principal and all interest
P = principal amount
i = interest rate
n = number of years
Now let’s apply the formula…
Let’s stick with the same parameters that we used in the simple interest example above. The investment is a 3-year $1,000 Certificate of Deposit. However, in this case, the 10% interest rate will be compounded annually for the three years.
Using the compounding interest formula, here’s the result:
M= $1000 (1 + .10) 3 = $1331
So through the magic of compounding, you would make $31 more over three years when compared to having your money in an investment that offers simple interest. That may sound like peanuts to you, but take it a step forward.
Imagine if the principal amount was $10,000 or $100,000, and the investment period was extend to 5 or 10 years. The differences would be even more glaring. If you want to see the formula in action, just plug some numbers of your choosing into this Compound Interest Rate Calculator.
And keep in mind that some investments may offer compounded interest rates that are calculated more frequently than annually — such as quarterly. The more frequently compounding is applied, the more money you’ll make (or pay).
I think the examples I just presented are pretty clear as far as understanding the impact of interest rates on investments such as CD’s, bonds, and savings accounts. But what about mutual funds, you ask?
Well, there is a slight tweak here. You see, one way that your mutual fund balances can grow quickly over time is when the dividends, interest, and profits they earn are reinvested back into the funds. The reinvested amounts are used to purchase more shares on your behalf. This is a form of compounding that essentially works the same way as the example I provided.
Now let’s move on to how compounding can work against your wealth-building efforts. Like I said earlier, it’s a double-edge ninja sword.
Let’s start with one of your credit cards. Maybe it carries a current annualized rate of 14% and it has an outstanding balance of $5,000. If this was a “simple interest” rate, you would do the math and the annual interest on the balance would be at most ($5,000 x 14% = $700) for the year.
But it doesn’t work that way. Instead, interest is applied to the outstanding credit card balance every month. And if you’re making new purchases and paying the minimum amount, then you’re going to be accumulating more interest charges and paying interest on that interest.
The bottom line is that each of your credit card purchases will be charged interest after a certain grace period. Perhaps it’s 30 days in your case. Interest is then charged on that outstanding balance every month until it’s paid off. Here’s a credit card payment calculator that can help you understand the impact of making minimum payments.
Now let’s talk about home mortgage loans and how compound interest makes banks very rich. Let’s say that you do the bank or mortgage company a huge favor and lock into a 30-year mortgage for $200,000 at an interest rate of 5%.
If your loan rate was treated as simple interest, you would pay a total of about $155,500, in interest alone, over 30 years. To come up with that number, I just assumed that you would pay interest on the outstanding balance at the beginning of each year,
Of course, that’s not the way mortgages today are handled. The mortgage company has factored in compounding. As a result, the total interest payments over 30 years would actually be $186,500. That’s a $31,000 difference. It’s also why I favor 15 year mortgages but that’s a topic for a separate rant.
How to Use This Information
Now you see that compound interest rates and compounding, in general, can work for or against you. But regardless, this knowledge puts you in a better position to make smarter financial decisions.
For example, if you see that the rates of return on your mutual funds are less than your credit card interest rates, that should signal an imbalance that’s not working in your favor. Why pay the credit card companies more in interest than you’re taking in through investments?
So you should consider one of the following strategies. You could redirect some of your mutual contributions toward paying off your credit cards faster. Or, you could consolidate and transfer your credit card balances onto a single card that has an interest rate that is less than the rate of return on your mutual fund investments.
For your mortgage, you may want to refinance your home and get a 15-year mortgage, or double up on your current monthly payments to erase your 30 year mortgage in half the time. Either way, you’ll pay a lot less in interest.
In conclusion, you now know why compound interest is the 8th wonder of the world. It can work for or against you in remarkable ways. Naturally, you should avoid or minimize situations where these types of rates can strain your budget and drain your wealth.