You have probably heard about compound interest, and might even feel you understand the notion of compound interest quite well, but since it is the key concept in some of the next steps and because the impact of compound interest over time might be far bigger than you realize, this entire step is dedicated to looking at how compound interest works.
In finance compound interest is one of the most powerful factors at work that by using time as it catalyst, can do one of two things:
- keeping you poor by losing money on outstanding debts
- making you richer by making more money with the money you already have
Let’s look at how compound interest works and how it generates this power over time.
When people or organizations borrow money they are often charged interest until they have paid back their loan. Say you borrow $1000 from the bank then you pay the bank interest on top of the original $1000 you are due to pay back. If you lend somebody or an institution money, you receive money on top of the money they are repaying. (This is essentially what happens when you have a savings account with a bank: you are lending your money to the bank and therefore receiving interest).
Compound interest is interest that is accumulated from interest over interest over interest over interest.. and so on. This happens because any interest isn’t just calculated over the orignal loan, but also on any interest received up til now. Every new year that therefore adds a little more over which to calculate more interest.
Imagine you have $100 in your bank account and you receive an annual interest rate of 5%. That means that after 1 year you get 5% over your $100 added to the $100, making it a total of $100 + $5 = $105. Now let’s say you don’t touch your money at all and leave it in that bank account for another year. After that second year, you again receive 5% interest. This time you don’t get 5% over $100,-, but over your current value of $105. That basically means you get 5% over your original $100 and another 5% over the $5 that you received last year as interest. This year you therefore get $5,25 added to your bank account, leaving you with a total of $110,25. The year after you receive $5,51 in interest, and after the 4th year $5,79. As you can see, each year the amount you receive increases compared to the year before, as your balance also increases. After 5 year the account would have over $127 in it, after the 10th year it would be more than $162 and after 25 year this amount would have grown to $338. Not bad for a starting balance of $100!
Now let’s say that instead of leaving the $100 in the account without doing anything with it for 25 years, you are actually able to save $100 each year and you put that money in this account. The following with happen to this money if we get the same 5% each year: After 1 year, when you have saved up $100, it would be the same as in the example above: you’d get 5% interest, so $5, making it a total of $105. After 2 years however, you’d have saved another $100, so you now have $205 in your account. When you get your 5% interest, you now get $10,25, making it a total of $215,25. The year after you would get $16 interest, and after 5 years, you would have a total of $580 in your account. After 10 years this would have grown to $1321 and after 25 years the amount would now be $5011.
The interesting fact in this second example however is that after 25 years you would have paid only $2500 ($100 each year), but your capital would have more than doubled! And that, my friend, is what is known as the power of compounding interest.
If we take it even further and say that instead of paying $100 per year, you are able to save $100 per month, after 25 years you would have paid $30.000, but your balance would be just over €60.000. We can go on about this for quite a while, but I hope you more or less get the point 🙂
Unfortunately the above isn’t always as rosy as it might sound, for two reasons. First of all at the time of writing, interest rates are far below the 5% I mention here. The reason for this is that during financially healthy times, interest rates are usually higher, during a recession or low financial growth, the interest rates tend to drop, in order to encourage people to borrow more money, thereby stimulating the economy. Hopefully we will soon see an improved economy with improved interest rates again, but for now we are stuck with historically low rates that are close to 0%.
A second reason why the accumulated money might not be as fantastic as it might appear now, is that due to inflation, money loses its value over time, meaning you can buy less for the same amount of money.
Bearing these two factors in mind, as long as the interest you receive is higher than the inflation rate, you are still better off and making money with the money that you have in a savings account that gives you interest.
Now let’s move on to what to do with this information.
Step 20 – Compound interest – in detail
- It’s a short and sweet action plan today, which will get us ready for later steps.
- Look at all the debts that you put together in step 4 and check you have all the interest rates on each outstanding debt listed.
- Put together a list of any savings accounts that you have and find out the interest rate that you are receiving on them at the moment.
- If you want and enjoy playing with numbers, go ahead and do a search on the internet for interest calculators, and play around with the amount of money you might be able to make with current interest rates and an amount of money you have in your savings account.
Unfortunately compound interest doesn’t just have a positive effect on your finances by giving you interest on savings money, it can also have a negative result in the form of interest that you need to pay on outstanding loans. We will look at this in the next step.