Compound Interest: The Good and the Bad

Compound interest is like a superpower: It can be used for either good or evil. The sentiment can be summed up in a famous quote by Albert Einstein,

“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”

Money Stacking On Top of More Money

The best way to think about compound interest is as a kind of momentum that feeds off itself. It can do this in a positive or negative way. This phenomenon can play a vital role in helping build your net worth.

Compound interest on your savings or investments will help your money growing consistently over time. It’s as if money keeps stacking itself on top of more money.

The Sooner the Better

The earlier and more you can save, the more money you will end up with. The most important factor is timing. Starting early is more important than saving more.

For example, let’s assume you want to have $1 million dollars by age 65. The stock market has historically returned an average of 10 percent annually, before inflation. However, for this example, let’s work with a very attainable annual rate of 6 percent.

If you began saving at age 20, you would only need to allocate $361.04 per month to reach your goal. If you started just five years later at age 25, your monthly investment would need to increase almost 50 percent, to just shy of $500.

So, if you began at age 30, that monthly total would nearly double to just below $700 a month. Now, if you’re like many adults who don’t recognize the need to save until they hit age 40, the monthly allocation shoots up to $1,435.83. This is the equivalent of a mortgage on a small home.

All is not lost if you start later in life, as compound interest will still help you build your net worth. And with people working and living longer, we have more time than any generation before us. Don’t let a late start deter you from starting at all.

Compound Interest and Debt

Compound interest can also have a negative impact on those with long-term debt, especially those with student loans that include any kind of deferment. While income stacks on top of income when you are saving or investing, debt also stacks on top of debt. This happens when you have a late or missed payment, and additional interest is added to your principal.

The impact of compounding increases depending upon the frequency at which the interest rate compounds. Credit cards, for example, typically use daily compounding.

Compound interest is a powerful financial force that can work for you or against you. Learning how to use this to your advantage can help get you in a comfortable position later in life.