We hear a lot about compound interest, and how it can help you build your retirement.
Indeed, the power of compound interest is the subject of many articles on how to build wealth over time.
Even though compound interest is powerful, it’s not just a force for good. In fact, compound interest, like so much in the world of finances, is itself neither good nor bad. It’s how you use it that matters.
Understanding how compound interest works is essential.
A quote, commonly attributed to Albert Einstein (although it hasn’t been completely substantiated), points out that, “Compound interest is the eighth wonder of the world. He who understands it earns it, and he who doesn’t pays it.”
Compound interest can work against you just as well as it can work for you.
The key is to earn it — and not pay it. Debt is the way that you pay compound interest, and it works against you.
Simple Interest vs. Compound Interest
Whenever you borrow money, you pay for the privilege. A lender expects to compensated for the use of its capital. This compensation comes in the form of charging interest on the amount you borrow. A percentage of your loan is charged to you as a fee.
There are two ways that interest can be figured. Simple interest is only charged once, on the loan total. Your interest charge might be spread out over the life of the loan, but it is charged on the principal only.
Compound interest, though, is interest charged on your interest. With compound interest, the amount you owe in interest is figured periodically. That total is added to the balance, so next time interest is determined for the period, the interest you owe from previous periods is included, and you pay interest on that as well.
Consumer Debt: Compound Interest Works Against You
Credit cards are among the most common loans that employ compound interest in a way that works against you.
This is because the compounding is likely to take place more often. This means that your interest is often added to your total balance, adding to the amount of interest you pay down the road.
One common way for loans to be compounded is on a monthly basis. If you have a credit card with interest compounded monthly, with a 12% APR, then you are charged 1% each month. You might be charged on your balance at the end of the month, but you are more likely to be charged on the average balance you carried for the month.
If your average credit card balance is $2,000 for the month, your interest charge at 1% for the month would be $20. That $20 is added to your $2,000. The next month, you would be charged on $2,020, so your interest would be a little higher, at $20.20. Over time, though, the extra adds up, since you continue to pay interest on your interest. [These figures aren't showing any amounts paid off and are assuming there are no additional charges to the card.]
Not all credit cards compound interest monthly, though. Some of them compound interest on a daily basis. This means that you pay a little more, since you are charged interest each day. If you have a card that charges 15.99% interest annually, on a daily basis that’s 0.000438% charged every day. If you have a $3,000 balance, you will have $1.31 added to your balance at the end of the day. The next day, you will be charged interest on $3,001.31. It seems like a small thing, but over time it adds up.
It’s true that each month you make payments on your debt.
However, if you are only paying the minimum, you will be hard-pressed to keep up with the compound interest you are being charged. You might have a minimum payment of $45, but if $20 of that is going toward interest, then only $25 of it is actually reducing your principal. That’s a pretty slow rate if you want to pay off your debt.
Over time, paying interest on your interest adds up.
The longer you pay compound interest, the more money you pay straight into someone else’s pocket. As long as you are paying interest, you can’t use your money for your own benefit.