What is compound interest?
“Interest” as most of know, is the price we pay for borrowing money – whether from a bank or on a credit card or from other sources. The amount you borrow is called the ‘Principal’. If I borrow $100 at 5%, then at the end of the first year I will owe you $100 + $5. In compound interest situations, the two are added so that for year 2, it will be as if I had borrowed $105 (and not $100). If you are saving money, then compound interest works in your favor, but if you are borrowing money (say, against your credit card, it can work against you). Most borrowing is at compound interest rates. Borrowing money in any form is therefore a sure way to financial problems.
Assuming you have made savings that are compounding for you, then this is a happy situation. Not only is your money earning interest, but the interest you earned earlier is also earning interest. Over time, you see the power how interest could either affect you in a positive way (if saving money) or in a negative way (if in debt).
What is the rule of 72?
The Rule of 72 Formula: Divide The Interest % Into 72 To Estimate The Number Of Years To Double Your Principal*
This is a very general rule that says that if you are earning (say) 4% compound interest on your savings, then your money will double in 72÷4=18 years. If you invest $100,000 at 8% then your money will double in 9 years. If you were able to get a 8% return, then your money would double every 9 years. (72÷8=9 years). Let us see what happens when you put aside $100,000 when you are 26 and are 62 years old now (just when you need money for care giver and advanced health care).
Every 18 years
Every 9 years
At age 62, in the 4% scenario you would have $400,000 whereas in the 8% scenario, you would have $1,600,000 – surely giving you a far better quality of life.
Compound interest can also bite!
As I mentioned briefly earlier, compound interest can also hurt you tremendously if you are not careful. Let us say that you have a credit card debt of $5,000. The company charges you an Annual Percentage Rate (APR) of 15.99% and that you pay the minimum amount due every month every month (which is presently $110).
Don’t read ahead, how many years do you think it would take to clear the $5,000 in debt? Say 3 or 4 years? Right? WRONG! It will take you around 25 years to clear the debt. You would pay $12,005 over 24 years and 11 months! No wonder the credit card companies love the concept of paying only the minimum amount due.
What if you were to pay a fixed amount of $110 (and not the minimum due) plus $50 extra per month? Surely you can do that. See the difference, your time to pay reduces to just 41 months and you pay the company a lot less – $6,560 against the earlier $12,005.
Is compound interest working for you or against you?
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*This is a hypothetical scenario used for illustrative purposes and does not reflect the results of any specific investment. The actual time it will take an investment to double in value cannot be predicted with absolute certainty because performance of investments fluctuate over time.