Compound interest plays a huge role in our lives if we have any debt or are investing.
It can make paying off a loan significantly harder or help you become a millionaire by the time you retire. To understand compound interest, you need to know its power - from the good to the bad.
To understand compound interest, key aspects of the definition need to be broken down.
First, compound interest will apply to loans or investments. There is a principal amount and interest associated with your loan or investment. All of these things have a factor in understanding compound interest.
There is an initial amount that you have down for all loans and investments.
So, for example, if you take out a $10,000 loan, $10,000 is the principal amount.
When you have a loan or investment account, you will have some type of interest.
For a loan, the interest is the additional amount that you owe your borrower for them to make a profit. For an investment account, the interest is the rate of growth/losses that your account will have.
Compound interest is the interest on your loan or account based on the principal and accumulated interest.
This is essentially having interest on your interest. Compound interest grows much faster compared to simple interest. Simple interest is the interest on your loan or account based solely on the principal amount.
To really understand compound interest, it's important to see how it works in real-world scenarios. Especially one good and one bad scenario.
Compound interest can be a powerful tool for investing.
The younger you start saving, the more money you have to save for a larger portfolio. Two people can save $2,000 a year at different ages in their life, and the person who started younger and stopped investing after a few years will have more wealth - all because of compound interest.
Person 1 starts to save $2,000 a year at the age of 21 but stops at the age of 30. He saved $18,000 over nine years into a basic retirement account.
Person 2 only starts to save $2,000 a month at the age of 30 and continues to save this amount until 68 years old. Person 2 saved $76,000 over 38 years in a basic retirement account.
It may seem like Person 2 will have more money saved up for retirement, but it's actually person 1. It's helpful to look at the numbers to see why.
Let's say these two individuals invest in an S&P 500 index fund at a rate of 12%.
Person 1 will have 2.35 million dollars at the age of 68! Person 2 will have 1.3 million dollars, which is still a significant amount of money but less than person 1. This shows you how investing at a younger age can impact the wealth you can accumulate in your lifetime.
Let's break down how this is possible. A 26-year-old has $20,000 saved for retirement and will not add any more money to this account.
That 12% really compounds the more money you have year after year. In another six years, their account will reach 2 million. It took 33 years to get 1 million in their account, but six years to reach another million.
Student loan debt is a national crisis.
Many people cannot afford to pay their monthly payments, and trying to pay off their debt seems impossible. A lot of this is due to compound interest.
Let's use a person's average student loan debt at $37,000.
At this interest rate, after a ten-year standard repayment plan, you will pay over $8,600 in interest on top of the $37,000 original loan. If you pay less than this amount, your overall payments will grow, even more, making it harder to pay off your debt.
What happens with compound interest is that you start with $37,000 of debt.
If you did a lower payment plan, you'd see the impact of compound interest, making it more challenging to see your principal amount go down.
For example, if you are paying $100 a month towards your loan, you would still have $30 left towards the interest that was not paid. That total will be added to the principal, and the interest for the next month will be calculated on top of that.
If this were simple interest, the interest would only be calculated on your principal amount and none of the interest that is accrued. So you won't avoid interest, but the interest will not be as much.
To combat the negative aspect of compound interest on debt, try to make extra payments to reduce your principal and overall interest. Starting this early can help make paying off debt a lot more manageable.
Compound interest can be a friend and an enemy.
It can help you while you're young by increasing your wealth, but it can also may debt payments challenging and almost impossible. Always try to pay off debt early to make debt repayment more manageable. Try to invest today instead of tomorrow to add more time to the growth of your investments.
