Updated: Oct 19, 2018
I know I know… the title of this blog is a bit dramatic, but it couldn’t be more true! Understanding this one concept that I’m about to teach you will make or break you financially. Many personal finance topics are important, and I like to think that I’ve taught you a fair amount thus far. However, I’ve been waiting to release this blog because you first needed to understand the concept of Debt and the concept of Investing which we’ve covered in detail. So now we can finally discuss the most critical concept in your financial life. Albert Einstein has quoted this concept as “The most powerful force in the universe,” and others have coined it “The 8 Wonder of The World”. I am talking about nothing other than Compound Interest!
So what is Compound Interest? Compound Interest is the addition of interest to the principal sum invested, or in simple terms, the earning power of interest on interest. Let’s look at an illustration for better understanding:
Compound Interest - If you invested $1000 for 10 years and received 5% interest on your money. At the end of 10 years, you would have about $1630, earning $630 in interest.
(Math = 1000(1+.05/10)^10)=$1,628)
This increase may not seem like a big deal but let’s increase the stakes a bit. If you invested $100,000 for 40 years at a 10% interest rate how much money would you have? Drum roll, please…… $4,525,926! What just happened you ask? Compound interest just happened! Compound interest over long periods of time causes substantial growth. Again, why I encourage everyone to start investing as early as possible. So now that we understand how amazing compound interest is at growing our wealth, I have some bad news for you. IT WORKS THE SAME WAY IN REVERSE WITH DEBT!
As the saying goes “If you’re not earning compound interest, you’re paying it,” and unfortunately many of you are on the wrong side of the compound interest equation. Compound interest works the same way on the debt you owe but just in favor of the other party. Let’s look at a credit card example:
If you owe $5000 on a credit card with a 20% interest rate and you make the minimum payments of $150, how long do you think it will take you to pay off the card? Better yet, how much interest will you pay? It would take you 220 months (18.4 years), and you would pay a total of $10,861! That’s $5,861 in interest alone (over 100% paid in interest) which is more than the original money borrowed! This is why it is vital for you to get out of debt as soon as possible and swing your way to the positive side of compound interest.
In summary, compound interest is one best advocates for your wealth if it’s working for you and one of your worst enemies if it's not. So always remember, “He who understands it…earns it…he who does not…pays it.” So the question is, which side are you on?