Compound interest. Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.” Being in the personal finance space, I must agree 100% with this statement. 

But wait, what exactly is compound interest? 

As defined in Investopedia, “Compound interest (or compounding interest) is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods.” In other words, it is interest on interest on interest.  

Since interest comes in different forms (e.g Annual Percentage Rate (APR), Annual Percentage Yield (APY) performance returns), the compounding affect can be your best friend, or your worst enemy depending on the financial product. So today we’ll be discussing the good, the bad, and not so ugly part of compound interest as it relates to your finances. 

The Good…Investments

A 401(k). 403(b). Thrift Savings Plan. Roth IRA. Health Savings Plan. Crypto. ETF’s. The list goes on! Although it might be a scary topic, investing your money is actually one of the main ways to actually build wealth whether you like it or not. 

In regard to interest, this is usually called Return on Investment, Money-weighted returns or time-weighted returns. Essentially, they all just measure the profitability of a specific investment over a  set  period of time. With the average annual return of the S&P 500 index being roughly 10% over the past 30 years, this is truly the form of interest you don’t want to miss out on. 

Just to show you how powerful this type of compounding can be, check out the chart below. This scenario shows a starting or principal balance of $6,270, monthly contribution of $157, and an annual return of 10% (assuming following the S&P 500 index). 

I’ll caveat by saying past performance does not indicate future performance, but you have to admit that this is crazy. Based on this scenario you would earn roughly $6,000 in gains based off of contributing $15,690. That is almost a 38% return over 5 years! That is why it is said “you can’t save yourself to wealth”. 

The Bad…Debt

Specially, the bad would be high interest debt like a credit card. The plastic card has its perks such as cash back, points towards flights, or even first pick at concert tickets. But this plastic card could easily get us in trouble if we start using it like it’s our own money. 

With the annual percentage rate (“APR”) on a credit card being roughly 18%, that compound interest is something to be afraid of. Think of APR as the full amount you will pay for a loan over the course of one year. It includes any fees you may need to pay, plus the interest rate a lender applies to your particular loan. As such, APR has a huge impact on the actual amount that you owe on the credit card balance. 

If you don’t believe me, check out this chart below showing how much interest you would be paying for a $6,270 balance (average CC debt according to Value Penguin), with 18% APR, with making the minimum payments ($157) over 5 years. 

A whopping $3,376 in interest payments! I don’t know about you, but it scares me to think about how much compound interest can negatively impact our finances. Remember to always try to pay more than the required minimum when it comes to paying down credit card debt. By just adding an extra $100 per month on that $6,270 balance, it would cut the interest by more than 50%! 

The Not So Ugly….Savings

Annual Percentage Yield, also known as APY, is the annual rate of return you earn on cash in a savings account if you keep the account for the full year. I like to think of APY almost like free monthly increments of money for simply saving. This is not to be confused with annual percentage rate (APR) which is the cost of the loan (e.g. fees, interest). APY is one of the main perks associated with a savings account offered by a financial institution. 

Currently, the average APY of a High Yield Savings (HYS) account is around 0.5%. Not too shabby for cash that you are sitting on, but not as good as those investment returns we talked about earlier. 

But check out this visual below to show you how much interest you would earn with the same initial deposit of $6,270 and monthly contributions of $157 from our first scenario while in a HYS.

As you can see, compound interest impacts our financial lives whether we like it or not. At least you now have information that allows you to determine how compound interest specifically impacts you. If you have debt, make that extra payment to cut down on the amount of interest you’ll owe. For your savings or investments, consider increasing the contribution so you can earn more. As always, we got you covered if you have any questions. 

Holding You Accountable, 

DWM

Sources:

https://www.experian.com/blogs/ask-experian/credit-card-payoff-calculator/

https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator

https://www.marcus.com/us/en/financial-calculators/high-yield-savings-calculator