“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”– Albert Einstein
Compound interest is a financial concept I really, really wish was emphasized more in the United States’ education system. Of the many subjects taught in school, all of them with some value and most of them with a good deal of value, personal finance would benefit all students (and probably most teachers). A good friend and mentor summarized our shared view regarding the lack of personal finance curricula in formal education: “Why do we spend 12 years in first through twelfth grades, then four more years in undergraduate education, and sometimes several more in additional schooling learning to be better workers only to graduate and have no idea how to manage the money we make?”
The first time I recall a teacher in a formal school setting emphasizing the power of compound interest was in graduate school in an MBA finance class where the teacher, thankfully, spent his first class providing students two hours of personal finance education. While I was well aware of the power of compound interest by the time I entered the MBA program and had also spent many years investing by then, I was also aware that many people see personal finance as overly complex, so I was glad the rest of the class was getting this lesson.
Compound Interest Giveth
As I wrote previously in Part 4 of the Personal Finance Foundation series, compound interest is a powerful tool for growing wealth over time. Investing money at a given interest rate over a given amount of time can produce huge growth. Increase either the interest rate or the amount of time the money is invested, or, better yet, increase both, and you’ll see enormous transformations.
Example 1: Roth IRA, $6,000 contributions, 30 years, 6% interest
The 2020 IRA contribution limits allow you to contribute $6,000 annually. If you were to contribute $6,000 annually for 30 years and receive a return of 6% annually, in 30 years you would have $508,810.06. Note that of this amount, $186,000 are contributions you made and the remaining $322,810.06 is interest earned. I want to emphasize that the $322,810.06 is money your money earned for you, and is not money you traded time, energy, sweat, or tears for.
Example 2: Roth IRA, $6,000 contributions, 30 years, 8% interest
Holding all things equal (maintaining the $6,000 annual contribution for 30 years) and raising the rate of return to 8% would result in you having $740,075.21 at the end of 30 years. This is $231,265.15 more than the amount you would have in the previous example. The power of even a slightly larger interest rate invested over time is clear in this example, as just a 2% increase in the rate of return results in a huge difference.
If you use recognize that the maximum allowed contribution to IRAs has increased over time, it stands to reason that in the future you could increase the $6,000 contribution you’re making, resulting in larger returns over time. Further, the 6% and 8% interest rates I used are below the average rate of return for the S&P 500 stock index for the past 30 years. With dividends reinvested, the 30 year annualized return for the S&P 500 is 9.4% as of May 10, 2020. I purposely chose the more conservative 6% and 8% rates of return because I prefer to estimate my returns conservatively. In other words, I’d rather play it safe in estimating how much money I may have in the future rather than relying on too high a rate or return and then finding myself without enough cash in the future.
While compound interest can grow your net worth immensely over decades, it can also be an immense drain on your financial health. Here’s how.
Compound Interest Taketh Away
A prominent financial voice and personality has often spoken of the ease of finding investments that reliability generate 12% interest. While I find his claim questionable, there is a financial liability that can drain you of money at a much faster rate than 12%, guaranteed: Credit cards.
I use multiple credit cards that give rewards for spending and they have a range of interest rates from 9.9% on the low end to 17.99% on the high end. The card charging 9.9% was issued by a credit union and the 17.99% interest rate belongs to a Chase cash back credit card. While we as savers and investors seek saving and investment vehicles that produce the largest interest rates, it’s also important to consider what we do when we carry credit card balances: We choose to pay credit card companies interest rates that are much higher than we can (most likely) find on our own in investment vehicles. I’m going to walk through a couple of examples to demonstrate the amount of money you hemorrhage by carrying balances on credit cards from month to month.
Example 1: A credit card with a 9.9% interest rate, a $10,000 balance, and an $84 minimum payment
If you have a credit card with a 9.9% interest rate, a $10,000 balance, and pay an $84 minimum payment until you pay off the credit card, you’ll get the following results:
Expected payoff time: 490 months (about 41 years)
Interest paid: $31,154
Insane! $31,154 of interest. You can see how people trying to get out of the credit card debt hole by making minimum payments, or close to minimum payments, often feel like they’re on a hamster wheel, barely able to make progress. Also, look at all that interest paid to the credit card companies that, alternatively, could have stayed in your pocket had you either paid off your balances immediately or had you paid them off much sooner.
Example 2: A credit card with a 17.99% interest rate and a $10,000 balance
If you have a credit card with a 17.99% interest rate, a $10,000 balance, and pay a $150 minimum payment until you pay off the credit card, you’ll get the following results:
Expected payoff time: 504 months (42 years)
Interest paid: $65,558
Again, if you only pay the minimum payment on a credit card, you’re going to spend a very long time paying off the balance. Granted, the examples above use a static minimum payment while you pay off the balance rather than adjusting the minimum payment based on a percentage of the balance, but the takeaways are the same: You need to pay more than the minimum payment on credit card debt, otherwise the interest you’ll pay will be outrageous. In this second example, consider that the $65,558 in interest is cash credit card companies are earning in their “investment” with a rate of return of 17.99%, all at your expense.
Getting Out of Credit Card Debt
Call your credit card company, explain your situation, and ask if you can have a lower interest rate. Especially during the pandemic, credit card companies are more likely to be empathetic, as they’d rather have customers providing them cash flow rather than customers unable to pay. Even if the credit card companies aren’t able to lower your rate, you’ll only have expended a short amount of time to call them, so make the call.
Identify spending that isn’t needed. If you’re not doing so already, track your spending with a budget or cash flow plan. I have a cash flow plan template you can download here in Microsoft Excel format.
There are plenty of other tools you can use for budgeting or cash flow planning, but your end goal should be to identify spending that isn’t needed.
Stop using credit cards and start paying the balances down. There are two popular strategies for paying down credit cards: Paying off cards with the smallest balances first in order to generate quick wins and to generate the associated emotional rewards (this is often referred to as “The Debt Snowball”), or paying off credit cards with the highest interest rates first (this technique is often referred to as “The Debt Avalanche”). Mathematically, the second plan of attack is best, but humans aren’t purely mathematical creatures, especially when it comes to personal finance. Both strategies have their merits.
- Pay off credit card balances every month. This prevents interest from accruing at enormous interest rates.
- If you’re working on paying off credit cards, strongly consider paying off credit cards with the highest interest rates first.
- Interest you’re paying toward credit cards is lining the pockets of credit card companies. Consider how you can pay yourself instead, namely through saving and investing, and grow your net worth.
- Once you’re done paying down credit card debt, build a habit of saving cash for large purchases so that you don’t jump on the hamster wheel again.
- Even better: Once you build up cash savings for large purchases, consider how you can start using excess cash for investments so that you can reap the benefits of compound interest.
I used a calculator from Credit Karma’s web site to calculate payoff times. This web site also provided the great visuals.