Don’t under estimate the power of compound interest. It can work for you or against you. According to Investopedia the definition of compound interest is: Interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. This concept is so powerful that Albert Einstein is said to have called compound interest the “eighth wonder of the world” and that “he who understands it, earns it… he who doesn’t, pays it.” Now whether Einstein said this or not, it’s a powerful statement nonetheless.
Compound Interest vs Simple Interest:
Most everyone has heard of this concept and it most often comes up when thinking about the growth of savings or investments over the long term. To review, interest can generally be calculated as compound or simple. There is a huge difference so you need to read documents carefully.
Simple interest is calculated by paying or assessing interest only on the original amount. For example, $10,000 is invested and the investment will pay 5% per year simple interest. This means each year, you will be paid $500. This is very similar to the way a bond pays interest.
Now consider compound interest. As stated above, this is where interest is earned or assessed based on the original investment plus the prior years interest. See the chart below for just how major the difference is.
*Rate of return of 5% is for illustration only and is not meant to represent the return of any spefic
Your results will vary. No taxes or fees were included in this calculation. Investing involves risk of
loss and investments are NOT guaranteed or FDIC insured.
Compound Interest: Make It Work For You
It’s important to remember compounding works in reverse and this is where it can work against you. Most likely, if you take out a mortgage, the interest is compounded monthly. When we’re about to make a huge purchase like buying a home, the primary concern is typically the monthly payment and whether or not it fits within our budget. However, even with low interest rates, it can be down right scary when you can see how much interest you will have paid over the course of 30 years
How much interest will you pay? Let’s take the following example: A $250,000 30 year mortgage at 4% will result in a principal and interest payment of $1,193.54 per month. This will cost you $179,673.01 in interest over the 30 years! You will have borrowed $250,000 and paid back $429,673.01. That is a huge number and you can thank compound interest for that. See below for a chart on total interest based on various loan amounts at 4%:
What can you do about it? Use compound interest to your advantage and make it work for you by making small additional payments to principal. Small steps now can make a huge impact down the road. Make the following additional monthly payments at the start of your loan for 15 years and see what happens:
|Additional Payment||Interest Saved||Loan Paid Off|
|$50||$13,168||19 months early|
|$75||$19,231||28 months early|
|$100||$24,976||37 months early|
Make sure you check first with your lender regarding their policy on additional payments and how they’re applied. There are other considerations too. When you make additional payments they are no longer available to make retirement contributions or other savings which can also utilize compound interest. There are also numerous variations on how and when to apply additional payments to principal for a desired result.
Understanding compound interest and making it work for you can save you thousands and thousands of dollars and help you get out of debt quicker. Be smart like Albert Einstein and make compound interest work for you.