Called the most powerful force in the universe, the miracle of compounding interest works in two very different ways:
- For good–you’re receiving interest on your interest
- For evil–you’re paying interest on your interest
You: Interest on interest?
Exactly. For example, take a basic savings account. Say you deposit $100 on January 1 to an account that pays 5% interest, compounding monthly.
You: Stop right there. What’s it mean to compound monthly again?
It’s the frequency at which you’ll earn interest. In this case, once per month. At the end of January, you will have earned interest in the amount of:
$1,000 x 5% x 1/12 = $4.17
(The 1/12 represents one month out of 12 there are in a year).
So your balance at the end of January is $1,004.17. In February, you’ll earn:
$1,014.17 x 5% x 1/12 = $4.18
You: There’s only a penny difference between the interest I earned in February and the interest I earned in January.
You: Why are you wasting my time with this? I need strategies that are going to move the needle by more than a freakin’ penny.
Whoa, there. This blog is rated G.
You: Well, c’mon, Michael – a penny?!
Obviously a penny isn’t a big deal. I could have made this example different, say by suggesting a $50,000 account balance and comparing one year to another (rather than comparing months). But if you’re just starting out, a $50,000 balance is a ludicrous example.
The real point is that it takes money to make money. The example just shows you how. That extra penny appears through no effort on your part. All you have to do is leave your previous investment earnings alone. As you are able to save more money for longer periods, the difference won’t be pennies – it will be sizable.
Compounding interest is an incredibly powerful force. Choose to benefit from it. Enrolling in your 401(k) plan as soon as you are eligible is just one great way to take advantage of this miracle.On the other hand, once you are buried in “bad debt,” such as high-interest credit card debt, you may find it impossible to get out from underneath. This is the miracle of compound interest working in its evil form. You will be paying extra pennies (more likely dollars) each month as the interest you didn’t pay last month has now lead to an ever-expanding total balance due.
You: What should I do ?
The best advice is to limit your spending to no more than your earnings so you never get in such a situation. But, if you are way beyond that point already, then do everything you can to . . .
Get rid of expensive debt first.
(a future posting)