Compound Interest: Best Friend or Worst Enemy?

Compound interest is the most important money concept on the planet. You may also hear it called compounding interest, which is the same thing.

Compound interest can make you richer than you ever imagined or dig you into a deep hole of financial ruin. In this article I’ll dive into what it is, how it can be your best friend or worst enemy, and what you need to do to reap the rewards.

Definition Break Down

Interest is the amount you receive if you let other people borrow your money. It’s also the amount you pay when you borrow money from someone else.

• If you keep money in a savings account, the bank borrows your money. They pay you interest as a reward for you letting them borrow your money. This concept applies whether you let a company or an individual borrow your money.
• If you need to borrow money from someone else, you take out a loan. When you take out a loan, there is an interest rate associated with it, which is the amount that you will owe in addition to the money you need to borrow. So if you take out a $1,000 car loan, you will need to pay the $1,000 back plus whatever interest you are charged.

Compound refers to the way the interest amount is calculated. There are 2 types of calculation methods you need to know.

Simple Interest calculates based on the original loan amount

• If you keep $1,000 in a bank account that pays you 10% simple interest, $1,000 is the original loan amount. 10% of 1,000 is $100 = the amount the bank will pay you every year as a reward for keeping your money there:
  • Year 1: Bank pays you $100, so your account balance is $1,100
  • Year 2: Bank pays you $100, so your account balance is $1,200
  • Year 3: Bank pays you $100, so your account balance is $1,300

and on and on and on….

Compound interest factors in both the original loan amount and the interest that has already accumulated.

• This time you keep $1,000 in a bank account that pays you 10% compound interest. $1,000 is still the original loan amount, but this time you will earn 10% interest on your entire account balance every year. Here’s what is looks like:
  • Year 1: Account balance = $1,000.
    • 10% of $1,000 = $100. New account balance = $1,100
  • Year 2: Account balance = $1,100.
    • 10% of $1,100 = $110. New account balance = $1,210.
  • Year 3: Account balance = $1,210.
    • 10% of $1,210 = $121. New account balance = $1,331

Compound interest is the clear winner when it comes to making money in interest. Because of this, almost all money is borrowed and invested using compound interest calculations, which can either be your best friend or your worst enemy.

Your Best Friend

Compound interest works in your favor when you invest, especially when you invest in the stock market. These investments use compounding interest principles, so you can earn a lot of money over time as long as you’re investing in the right things.

Using a Roth IRA calculator, let’s take a look at what happens when:

• You invest $1,000 in the stock market at age 20 and don’t plan to take it out until age 65. 
• You earn an 8% compounded interest rate of return (which is the average rate of return for the stock market)

That $1,000 turns into $31,290 simply because of compound interest!

Now what happens if you add $100 every month to your original investment of $1,000?

I know this sounds like magic but it’s not. You can use a Roth IRA calculator to test out these scenarios yourself. Compound interest definitely works out in your favor when you invest, and the earlier you start the better. I recommend opening a Roth IRA as soon as possible so you can take advantage of the incredible benefits of compound interest.

Your Worst Enemy

The downside to compound interest happens when you are the one borrowing money, especially from a credit card provider. Credit cards use compounding interest to charge you extra if you carry a balance on your credit card.

The interest rate is expressed as APY which means Annual Percentage Yield. The calculation is a bit more complicated because this APY is broken down to the daily interest rate, multiplied by your average daily balance, and then applied at the end of your billing cycle. 

Using a Credit Card Interest Calculator, let’s see what happens when:

• You have a $1,000 credit card balance and your card charges you 24% APY
• You pay a minimum payment amount of $30 toward this balance every month

$546 is just the interest amount – don’t forget that you need to pay off the original $1,000 balance too! This means that using your credit card and only paying the minimum payment amount actually costs you $1,546.

Compound interest can really dig you into a financial hole if you carry high balances on a credit card, like this:

• You have a $5,000 credit card balance and your card charges you 24% APY
• You pay a minimum payment amount of $100 toward your balance each month

$8,093 owed just in interest.

DON’T DO THIS. I repeat, please DON’T DO THIS.

While credit cards are an important financial tool, if you don’t use them wisely then you can find yourself owing way more than your original balance like in the example above. Pay off your credit card balance IN FULL every month. If you don’t, the principles of compound interest will make sure to dig you into a giant hole of credit card debt quicker than you thought possible.

Takeaways

• Compound interest applies to your entire account balance, not just your original investment or loan amount. This is awesome for investors, and horrible for people with credit card debt
• Open a Roth IRA and start investing right now to make compound interest your best friend
• Pay off your credit card IN FULL every month so compound interest doesn’t become your worst enemy

Disclaimer: I am not a certified financial advisor and this article is intended for educational purposes only.