Compound Interest: Making Money (or Debt) Grow

By Mike Peterson
In April 1, 2013

You’ve probably heard the term “compound interest” before.  But is it good, or bad?  Do you want it, or should you steer clear?  Well, that depends on whether you’ve got compound interest working for you, or against you.

 

Wealthy investors all over the world have long known how to make compound interest their friend.  But your credit company also knows the secret.  And if you’re carrying a lot of credit card debt, then you’ve got compound interest working to drain your bank account.

 

So what exactly is compound interest?  And how can use it to make you wealthier, not poorer?  Read on to learn more.

 

Compound Interest in a Nutshell

Let’s begin by defining compound interest.  Put (very) simply, “compound interest” means “interest earning interest.”

 

Here’s an example:  Let’s say you have $10.  You take that $10 and put it into some sort of account that earns 10% interest every year.  So, at the end of one year, you’ve earned $1 – bringing your total investment to $11.  At the end of the next year, you’ll earn $1.10 – bringing your total investment to $12.10, and so on.  As long as you keep that money there, it’ll keep on growing.

 

Compound Interest and Savings

You can probably see where this is going:  The longer your money earns compound interest, the more it earns every year – and the faster your investment grows.  This is why most finance experts will tell you that it’s better to invest now – even if you don’t have a huge initial investment, if you invest what you can, it will start growing.

 

In other words, it’s a good idea to invest as much as you can, as early as you can, to get the most out of compound interest.   Sure, it would be great if we all had an extra thousand bucks to invest – but the truth is, most of us don’t.  If we’re lucky, we can manage to scrape together a few hundred dollars.  And that’s the really great thing about compound interest:  You can take a relatively small amount of money and turn it into a serious chunk of change.

 

Let’s say you invest just $500 at a 10% return.  At the end of 30 years, your original $500 would become $8,724.70 – even if you didn’t invest another dime.

 

That’s the really great thing about compound interest – it’s accessible.  You can make compound interest work for you, regardless of your income level.

 

Want to see just how much you can earn with compound interest?  Try the U.S. Securities and Exchange Commission’s Compound Interest Calculator.

 

The Rule of 72

Looking to double your money?  The “Rule of 72” gives you a quick and easy way to see how quickly you can grow your investment.

 

To find out how long it will take your money to double at a specific interest rate, simply divide the number 72 by that interest rate.  For example:

  • If your interest rate is 12%, divide 72 by 12%.  You get six.  That means, it will take 6 years to double your money.
  • If your interest rate is 13%, it will take about 5.5 years to double your money.
  • If your interest rate is 14%, it will take about 5 years to double your money.
  • If your interest rate is 15%, it will take around 4.8 years to double your money.
  • And so on…

 

The Rule of 72 can also help you determine the interest rate you need in order to double your money in a set amount of time.  In this case, you’d divide 72 by the number of years.  For example:

  • If you want to double your money in 5 years, divide 72 by 5.  You get 14.4%.  So to double your money in 5 years, you’ll need an interest rate of 14.4%.
  • If you want to double your money in 10 years, you’ll need an interest rate of 7.2%.
  • If you want to double your money in 15 years, you’ll need an interest rate of 4.8%.
  • If you want to double your money in 20 years, you’ll need an interest rate of 3.6%.

 

 

Compound Interest and Credit Card Debt

Compound interest can be an incredibly effective way to make your money grow.  But compound interest can also have devastating effects on credit card debt, making it much harder to pay down a high balance.

 

Most credit card companies charge you compound interest – in other words, they charge you interest on your interest charges.

 

Here’s how it works:  Let’s say you have a balance of $2000, and your annual APR is 18%. If you pay off the card by paying equal payments over the course of one year, you’ll pay $201 in interest.

 

Now, you might think, if I pay $201 in interest per year, then to figure out how much interest I’d pay over ten years, I just multiple $201 by 10 right?

 

Wrong.

 

That’s because the credit card company is charging you compound interest.  So every time they charge you an interest payment, it adds to your overall credit card balance, and you pay interest on this entire balance.  (Not just your original purchase.)

 

The real numbers show that if you make ten years of equal payments on this same card, you will pay $2325 in interest.  That’s $315 more just due to compound interest.

 

Want to do the math yourself?  Check out this Debt Elimination Calculator.

 

This is why I’m a big believer in paying your balance off – in full – every month.  If you don’t have a credit card balance, you’ll never have to worry about paying hundreds or thousands of dollars in interest — compound or otherwise!

 

Start Saving – and Paying Down Debt – Today

Compound interest is a complicated subject.  I could probably write a book about the different ways that compound interest can affect you, your debt, and your finances.  The bottom line, though, is that compound interest is a powerful way to make your money grow – especially if you invest early.  The flip side to that, of course, is that compound interest can also make your debt grow.

 

My advice?  Pay off your credit card debt – quickly.  Then, invest your money and watch it grow.

Mike Peterson

Mike is the author of “Reality Millionaire: Proven Tips to Retire Rich” and he has been published in a variety of local and national publications including Entrepreneur Magazine, Deseret Morning News, LDS Living Magazine, and Physicians Money Digest. He holds a B.S. in business administration from the University of Phoenix.