Compound Interest: The Most Important Money Idea

Compound Interest: The Foundation of your Money Education

If there was just one simple topic you needed to understand to get a grasp on money, compound interest would definitely be it.

It's what makes rich people rich, and keeps the poor in poverty.
It's the make-or-breaker.
It's why debt is such a hard hole to climb out of.
It's why savers are able to retire.

Albert Einstein said, "Compound Interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't... pays it."

You can be very frugal, have a great job, and have a lot of support... but if you don't understand compound interest, you will be unable to make good financial choices.


So what is compound interest?


Here's the simplest way I can put it: it's the effect of time on money.

Okay, let's do an experiment. Let's say I offered you a choice: $10,000 right now, or $1 right now.

You'll probably take the $10k, right? Anyone would.

Let's add this: You can have $10,000 right now, or $1 right now, but the $1 would double for every day you didn't spend it.

At the end of Day 1, you'd have $1.
End of Day 2, $2.
End of day 3, $4.

Okay, doesn't seem too wild. Is the $10,000 still looking like the better option?

But if you kept going, you'd have over $16,000 by day 15, and you'd cross the million dollar mark on day 21.

Sounds crazy? See for yourself, the math checks out:




Now, this is an exaggerated example to illustrate a point. Nobody's going to give you an interest rate like this one. Nobody has that much money to offer you!

Let's try this again, with a realistic example: 22% APR on a credit card. And instead of savings, it's a credit card debt, so instead of this being money you've saved, it's money you owe.

Let's say you buy a $2000 couch and put it on the card. For the sake of argument, let's say it's a card with no payments due for three years, but the interest keeps piling up, compounding monthly.



At the end of the three years, you'll still owe the initial $2000 for the couch, with an additional $1777 on top of that lost to interest, for a total cost of $3777. That's almost enough to buy yourself another couch.

The best thing you can do when you have a debt is pay it off as soon as you can. As you can see, longer term debt benefits the lender, and the longer the snowball rolls, the bigger it gets.


Compound Interest Lingo:


  • Principal: The original amount of your debt or investment.
  • Interest: The money that your debt or investment makes (either for you, or for your lender)
  • Accrue: To accumulate, build up, or collect. Principal accrues interest.
  • Balance: The total amount. This could be the total amount that's left to pay on a debt.. or the total amount that your investment is worth. It usually contains principal and the interest it has accrued so far.
  • Compounding: When the balance of your debt or investment increases because the interest is making interest... and the interest's interest makes interest... and the interest's interest's interest makes interest... and... you get the picture.
  • APR: Annual Percentage Rate. If you have a debt of $100 at 22% APR, then every year they will charge you 22 dollars.
  • APY: Annual Percentage Yield. This is a sneaky way of factoring the compounding aspect of interest into the rate itself. I'll write about this later, join the mailing list and I'll let you know when I've written about it. For know, I just want you to know that they're different things so you aren't bamboozled.
  • Inflation: When money loses power over time. For example, back in the 1960s, soda cost 15 cents per bottle. Now it's $1.50. Was it cheaper then? Not really, considering wages were smaller too, and everything else cost less. The government tries to keep inflation at 2-3% yearly, although there have been times when it got away from them.

The Great Thing about Interest


On the flip side, the longer you invest, the better off you are.

Let's consider the S&P 500. The S&P 500 is an average of 500 major US companies' stocks. Since it's an average, it's a pretty good thermometer of how the stock market is doing.

Since the S&P 500 got started in 1928, it has had an average return of about 10% yearly. Remember when I said inflation is around 3% yearly? That's important because it shaves some power off of your compound interest. If your dollar buys fewer hotdogs now than it did 10 years ago, well, that's a drag and we have to account for that.

Adjusted for inflation, the S&P 500 returns about 7% yearly. What if we stuffed $1000 in the S&P today, added nothing, and forgot about it for 10 years?

Assuming it compounded 4 times a year, we'd have a little over $2000- half principal, half gains.

What if we did the same thing, but forgot about it for 30 years?

That $1000 would have grown to over $8000.

Now, these returns aren't promised, but they are based on history, and inclusive of every stock market crash from the great depression to the '08 crisis , so I think they're reasonable.


In Conclusion



If there's one conclusion I want you to draw from this, it's that time amplifies money. Time amplifies debt, and it amplifies investments. It amplifies for your benefit and it amplifies for your loss.

There is no avoiding this. even if you just stash money under the mattress, inflation acts like a compounding 2-3% interest rate.

An $8 lunch on a credit card can balloon to $16 if not paid off.
Deciding not to buy a $40 toy can earn you $100 if you decide to save that for your retirement instead.
Paying an extra $5 per week on your student loan can actually save you thousands of extra dollars by the time you pay the thing off.

Time. Amplifies. Money.

Share it. Teach your kids. Tell your mom. Put it up on your Facebook for your friends who didn't learn it from their parents or their school.

Never question or judge anyone's personal financial decisions. Our individual decisions are our own, and our priorities in life vary, but teach them if you can: time. amplifies. money.

I'm not telling you this because I want you to feel hopeless if you're in debt. It's the opposite. The you of today has more power than the you of tomorrow. Debt is not infinite, but it grows the most when it's ignored.

When you know more, you can make empowered decisions.

XOXO,
Meow


2 comments:

  1. Oh the magic of compounding interest. I have a love/hate relationship with it. I hate paying interest, but I love getting paid it.

    I was just showing a young coworker the power, and that he should start saving for retirement right away. That if he waited 10 years he lost out on an almost guaranteed doubling of that money - which was a cool couple million dollars.

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  2. Solid explanation for everyone interested in compounding. Thanks for sharing!

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