The following post is by MPFJ staff writer, Laurie Blank. Laurie is a wife, mother to 4 and homesteader who blogs about personal finance, self-sufficiency and life in general over at The Frugal Farmer. Part witty, part introspective and part silly, her goal in blogging is to help others find their way to financial freedom and to a simpler, more peaceful life.
At the root of many financial failures is the failure to understand the power of compound interest. Depending on which side of the river you’re on, compound interest can be a tool that will catapult your journey to financial independence, or a destructive enemy that will work to destroy your financial world.
Compound Interest: Your Wealth Building Friend
The effects of compound interest in the investing world are almost unbelievable. A commonly used scenario that works to illustrate the benefits of compound interest when used to grow wealth is this one:
At age 19, Joe decides to invest $2,000 per year in a retirement account for a period of eight years until he turns 27. He puts a total of $16,000 of his own money into an investment account, committed to leaving it there until he retires at age sixty-five.
Mike, also 19, decides to put off retirement investing until age 27, right when Joe decides to stop adding his own money to his retirement account. Mike puts $2,000 a year into his retirement account starting at age 27 and every year after that until age 65. Both men net an average annual return of twelve percent.
Who has more money saved in his retirement account when the men reach age 65?
Joe: $2,288,996
Mike: $1,532,166
(Source: http://www.daveramsey.com/blog/how-teens-can-become-millionaires )
It seems impossible, but any investment calculator will show you that although Mike contributed over $60,000 more of his own money to his retirement account than Joe did, Joe still ends up with nearly double the amount of money in his retirement account that Mike has.
This, my friends, is the wondrous miracle of compound interest.
Compound Interest: Your Financially Destructive Enemy
In the same way as compound interest can help you build enormous wealth, it can also assist you in systematically destroying any opportunity for financial freedom.
How? By continuously carrying high amounts of debt.
For example, if you carry a credit card balance of $15,000 (the average of credit card balance carriers in the U.S.), and your credit card has an interest rate of twelve percent, you could be paying on that credit card forever. If your card has a minimum payment due of one percent of the balance, the payment will match the monthly amount you’ll pay in interest and you’ll never make a dent on the balance, even if you pay on it for forty years. If you pay a minimum payment of 1.5%, it will take you over thirty years and over $40,000 in payments to get to a zero balance, as shown by the chart below.
The longer you hold onto debt – especially high interest consumer debt – the more that compounding credit interest charges will cost you money.
Credit card, mortgage and other loan interest charges not only eat up your monthly income, they take from you money that could be used to make compound interest your friend by using it to grow wealth, as in the first scenario I shared.
How to Turn Compound Interest from Foe to Friend
If you’re stuck on the wheel of compound interest destruction don’t worry; you can turn things around. Here are some tips for minimizing compound interest payments and freeing up more cash for wealth building.
Transfer Credit Balances to Low or Zero Interest Cards
If you’re carrying credit card balances that are too large to be paid off each month, work to transfer the credit card balances to zero interest card offers. Then work hard to get the balance paid off by the time the zero percent interest rate offer expires.
Crush Your Debt Quickly
The sooner you pay off your debt, the less of your money that will go into the profit margins of big banks and the more that will be available to go into your own pocket. Devise a debt payoff plan such as the debt snowball and get to work on crushing your debt.
Start Investing – NOW
Even if you can only afford to invest a little bit each month as you work to get out of debt, invest something. Get the power of compound interest working in your favor now, and increase the amount of money you invest as you are able.
Don’t let compound interest work against you any longer. Instead, use it to help you grow wealth and reach all of your financial goals.
How about you all? How is compound interest working in your life?
Share your experiences by commenting below!
***Photo courtesy of https://www.flickr.com/photos/torley/7072696591/in/
