Understanding Compound Interest: Making it Your Friend, Not Your Enemy

This is a guest post by Tom Becker, a personal finance writer at Money Choices where he impartially reviews high interest savings accounts.

Compound interest could be your best friend or your worst enemy depending on how you make or don’t make use of it. Albert Einstein was known to have called compound interest the “Eighth wonder of the world”, and it can be a fantastic way to allow your money to work for you. But as powerful a force as compound interest can be in affecting financial futures, there are still many people out there who do not recognize its true abilities.

Simply put, compound interest is regular accumulation of interest upon an investment, which in turn begins to earn interest upon itself. To explore compound interest further, let’s look at an example.

Simple Compounding

Take an investment of $10,000 earning interest at 6% annually. If you were to add 6% of $10000 to itself each year over 5 years, it would look like this:

• Year 1 = $10600 (10000 + 600)
• Year 2 = $11200 (10600 + 600)
• Year 3 = $11800 (11200 + 600)
• Year 4 = $12400 (11800 + 600)
• Year 5 = $13000 (12400 + 600)

Using the same figures, but compounding that 6% interest rate over 5 years, your totals would be different since the interest added each year would in turn be earning interest as well:

• Year 1 = $10600 (10000 + 600)
• Year 2 = $11236 (10600 + 636)
• Year 3 = $11910.16 (11236 + 674.16)
• Year 4 = $12624.77 (11910.16 + 714.61)
• Year 5 = $13382.26 (12624.77 + 757.49)

Comparing these two examples, you can begin to see the advantages of compounding interest. Now let us explore some scenarios where compound interest can either help our hurt our personal finances.

Credit Cards

One of the harshest lessons compound interest has to teach might be the credit card. While credit cards, used properly and paid timely, might can be quite benign, when abused, they can become extremely painful examples of compound interest at it’s finest (if you’re a credit card company) or worst if you are a credit card user or abuser.

With annual interest rates breaking the 20% range on many cards, you can only imagine what the compounding of this interest could accumulate to, even on a smaller balance, if it is not paid off on time. A balance could double in a matter of years at such a rate, making credit card interest one of the most dangerous examples of compounding to the average consumer.

Homes and Cars vs. Banks

There are many people out there who, when they receive a bonus, tax return, or similar lump sum cash payment might prefer to stash this money in a savings account or interest earning checking account than make an extra payment or two toward their home or car loan.

While there is certainly something to be said about having an emergency fund for when times are tough, you must also consider that the loans you have for a home, a car or similarly structured payment loan could be costing you money by way of their interest rates. And while a bank account might be earning you compound interest, it may only be doing so at an annual rate of one or two percent. Meanwhile, a loan could be costing you anywhere from five percent or more, meaning that the compound interest you’re earning in the bank is negated by the higher interest rates of your debt.

Building Your Future

Let’s say you have relatively little or no outstanding debt, or that the debt you do have has a very low-interest rate attached to it. Finding investment options that offer compound interest could be a fantastic way to build financial security for your future.

Investment options such as interest bearing savings or checking accounts, savings bonds, and certificates of deposit can be safe and easy ways to earn such interest. For such options as interest bearing accounts, you may often be able to earn higher rates by meeting certain thresholds or minimum balances. With certificates of deposit, the rate of compound interest you receive is often dependent upon the timeframe of the investment as well as amount invested, typically receiving higher rates for larger sums invested over longer periods of time.

Laddering Your Compound Interest Investments

Predicting what interest rates will be in five or ten years is difficult to do. This is where laddering your compound interest earning investments can be critical. Interest rates are almost constantly changing. It can be hard to know if what seems like a good rate today will still be there tomorrow, and putting all your eggs in one basket might not pay off. You might luck out and find that the rate you’ve locked into is a good one over time, but the opposite might be the case as well. To diversify your investment over different rates, laddering can help protect you from tying your money up for a long time at a low interest rate. Here’s how it works.

Example:

You have $3000 to invest.

Interest rates on a 1-year certificate of deposit are 1% with a $1000 minimum investment. Interest rates on a 2-year certificate of deposit are 2% with a $1000 minimum investment. Interest rates on a 3 year certificate of deposit are 3% with a $1000 minimum investment.

Since you don’t know if interest rates will go up or down next year, you may not want to tie all your money up for three years even though that is the best interest rate available. What would happen if rates went up to six percent next year? At the same time, if you only invest in a 1-year certificate of deposit, hoping that rates will go up soon, you’re taking the lowest interest rate available. And what if rates go down or stay the same next year?

Therefore, you decide to put $1000 into each of the three certificates of deposit. This way, if rates go up, you can reinvest that money as each certificate of deposit matures. If rates go down, you still have at least some money earning a higher rate of interest in the longer-term certificate of deposit.

Simply put, laddering is a way of hedging your bets against an unknown interest rate future while still reaping the benefits of compound interest.

Photo by JMRosenfeld