Law #11: Stop Paying and Start Earning Compound Interest
The Law
Compound interest can quickly separate the rich from the poor. Paying compound interest is the manifestation of a weak financial foundation, while earning compound interest is the manifestation of a solid financial foundation. Whatever you do, avoid paying compound interest like the plague, but chase it like the love of your life when you’re on the earning end.
Your Keys to Power
What’s the difference between simple interest and compound interest? Interest is the cost of borrowing money. When you borrow from a bank, you pay interest for the privilege of using money now and paying it back later. If someone borrows from you, you can charge interest for using your money that they'll pay back later. You can either pay interest or earn interest.
Simple interest. Simple interest is calculated based on the principal amount—the initial amount borrowed or deposited. When it comes to savings, the amount you earn is flat each month. When it comes to debt, the interest you pay is flat each month.
Compound interest. With compound interest, your interest earns interest when saving. On debt, your interest accrues interest. That means that your balance, either your savings balance or your debt balance, grows much quicker than with simple interest because the interest rate is applied not only to your principal balance but also to interest. So even your interest earns (or costs) interest.
Examples
Interest on savings:
Simple interest: If you have $1,000 in an account earning 5% annual interest, you'll get $50 a year.
Compound interest: If you have $1,000 in an account earning 5% interest compounded annually:
You’ll get $50 in year one
In year two, that $50 from year one is added to the principal, and you’d earn 5% on $1,050 = $52.50 in year two
Each year, you’d earn more than the previous year because you’d earn interest on interest. In year three, you’d be earning 5% on $1,102.50 = $55.13
As you can see, compounding interest on savings can have a large impact. While the difference in this example seems small, running this calculation out for 30 years would yield a difference of $1,821.94 on just a $1,000 investment. You’d have saved $2,500 with simple interest and $4,321.94 with compound interest.
Here’s a calculator to determine the potential return on various scenarios with compound interest.
Interest on debt:
Simple interest: If you borrowed $1,000 with an agreement to repay the loan in 3 years with 20% annual interest, you would owe:
Interest = $1,000 principal * 20% interest * 3 years = $600
Principal = $1,000 you borrowed
Total owed = $1,000 + $600 = $1,600
Compound interest: If you borrowed $1,000 with a 20% interest rate that compounds annually, you’d owe:
For the first year, you'll rack up interest of $1,000 * 20% = $200
In year two, your new balance would be $1,200, and you’ll rack up 20% on that new amount that included the interest from year one = $1,200 * 20% = $240
In year 3, your new balance would be $1,440, and you’d rack up 20% on that new amount that includes the interest from years the first two years = $1,440 * 20% = $288
So your total balance after three years of compounding is
Interest = $200 + $240 + $288 = $728
Initial principal = $1,000
Total = $1,000 + $728 = $1,728
As you can see, compounding interest on debt can have a significant impact. While the difference in this example is only $128 higher with compound interest, interest can compound annually, monthly, weekly, or even daily.
When would you pay compound interest? The types of financial products that can cause you to pay compound interest include:
Credit cards. You pay compound interest when you carry a balance on a credit card. The interest you owe on each statement cycle includes interest on your original purchases and the interest you racked up in the last statement cycle if you didn't pay in full. When you don’t pay enough to cover any new interest charges, that interest will get added to your credit card balance. The following month’s interest will be based on your new, higher balance. If you pay only enough monthly to cover the interest your credit card company charges on your balance, your balance would remain the same.
Student loans, mortgages, and personal loans. Money you borrow money for these kinds of things may accrue interest. If you don’t pay the interest charges within the period stated in your loan, you risk that interest getting “capitalized” or added to your original loan balance. When that happens, future interest will accrue on the new, larger loan balance, which will be higher than what you originally borrowed.
When would you earn compound interest? You’re not just earning interest on your principal balance with compound interest. Even your interest earns interest. Compound interest is when you add the earned interest to your principal balance, which then earns you even more interest, compounding your returns. Types of accounts and instruments that earn compound interest include:
401(k) accounts. The money you place in a 401(k) retirement account earns compound interest.
Savings accounts, checking accounts, and certificates of deposit (CDs). Interest rates on checking and savings accounts are meager these days, but when you find an account that earns interest, it compounds. That means the interest you earn is added to the balance in your bank account, and then future interest earnings are calculated on that new balance.
Stocks. Investments in long-term equities and dividend stocks both provide compounding opportunities. Long-term equities compound over time, and dividend stocks offer the same compounding benefit with the option to reinvest dividends paid out over time to obtain more stock.
Practical Application
Pay credit card balances in full to avoid compound interest. Do whatever you can to avoid paying compound interest. One of the quickest ways compound interest can come into your life on debt is by carrying credit card balances. Don’t do that. A credit card is not meant to finance the gap between the life you have now and the one you want. By spending more than you can afford to pay off each statement cycle on a credit card, you expose yourself to paying compound interest.
Pay off debt earlier than the term if possible. If you're exposed to compound interest through student loans, mortgages, or a personal loan needed for something critical, work to pay those balances off early. The quicker you pay those balances, the lower the impact of compound interest on your cash.
Put everything you can afford into accounts that earn compound interest. Put as much energy into making compound interest as avoiding paying it. If your employer offers a 401(k) retirement plan, enroll and invest up to the maximum you can afford. Try to max out the total contributions. Not only will you likely earn a percentage match from your employer, but you'll then earn compound interest. Work with a qualified investment advisor to explore other ways of investing in tools that pay compound interest.
Try not to make early withdrawals from accounts earning compound interest. The longer you let money earn compound interest, the faster it grows. Try to avoid making early withdrawals. You'll earn more in the long run by delaying your withdrawal for as long as possible.
Authority
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” - Albert Einstein
“Time is your friend, impulse is your enemy. Take advantage of compound interest and don't be captivated by the siren song of the market.” - Warren Buffett
“Little disciplines compounded over time make a huge difference.” - Orrin Woodward
“There will be good years and there will be bad years, but the compounding will continue on unabated.” - Pietros Maneos
“A modest rate-of-return can accumulate a fortune over time. You don’t need to beat the market, do over-leveraging, or pick the best stock to be rich. You just need to earn a decent rate-of-return and let your money compound overtime.” - Naved Abdali
“My wealth has come from a combination of living in America, some lucky genes, and compound interest.” - Warren Buffett
“If you understand compound interest, you basically understand the universe.” - Robert Breault
Our Vote
Compound interest is incredible, whether you're earning it or paying it. If you're earning it, it's incredibly beneficial, and if you're paying it, it's incredibly painful. I came to earn compound interest later in life than I wish I had. I was in my 30s already before I started to experience its wonder; however, I had been paying compound interest in some way or another since I was 18 years old because of how I used credit cards. These days, I don't carry debt. I use credit cards wisely as tracking tools or opportunities to earn points that I can redeem for perks, and I pay the balance off immediately. This simple practice helps me avoid one of the most damning aspects of compound interest. I earn compound interest in a variety of ways, mainly through investments.
Reversal
There's no reversal to this law. Please do everything you can to understand compound interest and find ways to earn it.