1. What is compound interest?
Compound interest is found on most loans and lines of credit. Interest is added to the loan’s principal amount on a regular basis (usually monthly, but it can vary).
2. How does compound interest work?
This is the most difficult part to really get. So, go over this a few times and ask questions if you still do not understand it. Do not be embarrassed. Most people take a while to “get it”.
Say you have a loan for $100 with a 12% APR (annual percentage rate) and interest is billed monthly. Let’s assume you do not make any payments.
Divide the APR by 12 months and you will have 1% each month.
Each month you will multiply your principal balance by 1% and add it to the principal amount. To make this really easy to calculate you can multiply by 1.01.
So, at the end of month 1 you owe $101.00 ($100 X 1.01). At the end of month 2 you owe $102.01. At the end of month 3 you owe $103.03. And so on until you reach the end of the year and owe $112.68.
See how each month your interest increases just a little more? That is compounding.
3. Why is compounding magic?
When you are dealing with investments this compounding effect makes your money grow even faster. This is why it is so much easier to retire a millionaire if you invest a little bit in your 20s as opposed to waiting until you are in your 40s to start investing.
4. What are the pitfalls of compounding?
While compounding can work magic when you are investing, the credit card companies and other creditors are using compound interest to make a lot of money off of you. This is why your credit card balance takes 30 years to pay off if you only pay the minimum monthly payment and can easily cost you more than triple what your current balance is.
5. How can I leverage compounding?
Use the power of compounding to your advantage:
– pay credit cards off each month… or even more frequently
– invest as much as you can, especially when you are young and retirement seems a long ways away (the minimum recommendation is 10% of your after-tax income)
– for low-interest loans, consider if your money could be invested at a higher interest rate than what you would save by paying off the loan (ie: if you have a loan at 3% and the opportunity to invest with a 7% rate of return you would be netting a 4% gain overall)
I know this was a bit more complicated than a lot of my daily tips, but it is an important one to understand if you are going to be financially free.