Whether you’re majoring in math, studying business, history or Shakespeare, there’s one fundamental finance lesson you should learn well before walking across the graduation platform and that’s the power of compound interest.
If simply reading the words compound interest just made your eyes glaze over, hear us out for just a moment. This concept could have profoundly positive or negative consequences to your financial well-being in the long run.
After all, 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.” To be sure you’re among those earning interest rather than one who’s paying more than necessary, here are four things everyone needs to know about compound interest.
It’s simpler than you think
When you stash your cash into a savings account, money market account, Certificate of Deposit (CD) or Individual Retirement Account (IRA), your financial institution pays you interest at regular intervals (annually, semi-annually or quarterly) on the amount you have deposited during that interval. As time goes by, the interest you earn on your deposits begins to grow substantially because you’ll start earning interest on your interest, year-over-year. This seemingly magical growth isn’t supernatural, it’s simply compound interest.
It truly rewards those who practice extreme patience
Compound interest will not provide instant gratification. Instead, your patience is its own reward. For instance, if you deposit $10,000 into an account that earns 2 percent interest annually, this deposit will grow and grow. However, it will move at a snail’s pace at first, then triple in size by the time you’re enjoying retirement:
- $10,200 after one year.
- $10,404 after two years.
- $12,189 after 10 years.
- $16,406.06 after 25 years.
- $22,080.40 after 40 years.
- $29,717.31 after 55 years.
You can level-up your earnings with regular contributions
If you add an additional $600 to that account each year (that’s just $50 a month or the cost of a cup of coffee a day), you would have $54,824 saved after 25 years. But after 55 years you’ll have $148,021.15 when all you contributed was $43,000 — that’s more than $100,000 in earned interest.
Just keep in mind that interest rates can vary greatly, depending on what your financial institution offers, how much you deposit initially and the type of account you have — with regular savings accounts typically paying the least and CDs or Money Market accounts usually paying more. Want to crunch the numbers for yourself? Use a compound interest calculator and discover your earning potential based on what you can realistically contribute.
While compound interest can be your friend, it can also be your frenemy
Just like you can earn compound interest when you’re saving, you can also pay compound interest when you’re borrowing. So you’ll want to keep the following in mind whenever you’re considering taking out a loan: the more you borrow, the higher the interest rate and the longer you take to pay it off, the more expensive it will become. This is true for your student loans, car loans and someday your mortgage.
But maxing out or carrying balances on credit cards is how you really bury yourself in debt because the interest rate is usually much higher compared to most other loans. Imagine that you owe $5,000 on a credit card with an 18 percent interest rate. Did you know that this debt will rack up $75 of interest charges every month? If you pay just the minimum of $85 each month, only $10 will go toward your principle (what you owe) and rest pays your interest. At this pace, it will take you 15.6 years to pay back $5,000 — costing you an additional $4,897.53 in interest.