I know, I know, the title of this post is a little bit click-batey. But that’s because what I have to share today is so important. I have a question for you: What do you know about compound interest? Compound interest is one of those things we’ve all probably heard of but never really taken the time to understand. The first time I heard about compound interest, my grandmother took me to the bank, got me a savings account and put $10 in the account. Then she said, “Look, your $10 is going to grow interest. Then that interest on the $10 is going to become your principle and that’s going to grow interest.” That was about all I used to know about compound interest. What I didn’t know was that if it could work for me, it could also work against me. Anyone ever heard of a credit card? Well, let’s talk about compound interest earning us money on our savings and killing our budget through debt.
The Eighth Wonder of the World?
When Albert Einstein learned about compound interest, he called it the eighth wonder of the world. He also said that “…he who understands it earn it … he who doesn’t … pays it.” Well, he must have understood it very well because to this day the Albert Einstein Estate is still making over $10 million a year due to compound interest (and licensing rights to his image)!
The Rule of 72
Have you ever heard of the rule of 72? Basically, this is how it works: you take the number from your interest rate, divide 72 by it, and that tells you how many years it will take for your money to double. For example, if you are getting 1% interest, you would divide 72 by 1, which equals 72, and you would know that it will take you 72 years to double your money in that account. How many 72 year time periods do we have in our lifetime? Usually only one! So my first piece of advice is to avoid 1% interest!
Normally when I teach this, I get someone at this point who asks if two or three percent can really make a difference on their account. That’s when I show them this!
Interest on Interest on Interest on…
Imagine you’re 29 and have $5,000 that you inherited from a long-lost relative. They give you this money with two conditions: 1) you have to save/invest the money somewhere, and 2) you can’t touch it until you’re 65. So you go down to the bank and open a money market account. And since they’re in a generous mood they give you 4% (The average money market account in this country ranges from 0.5% to 1.5% – and maybe a free toaster.)
So we take 72 and divide it by 4 to get 18. It will take 18 years for this $5,000 to double. At age 47 your account will have $10,000 and at age 65 it would double again to $20,000. Not bad, right? But why did it double? Well, remember my grandma from earlier? She was right. You see, every time interest is added to your account, it becomes part of the principle, or in other words, the new interest is calculated on the TOTAL amount in the account (initial deposit + any accrued interest).
Going back to our example, that first year the $5,000 made $200 in interest. The next year, when they added 4% interest, it wasn’t on just $5,000 but the total of $5,200. That was an additional $208. This meant the third year, that 4% figure was based on the total of $5,408, giving the account $216.32 of interest. As you can see, this adds up pretty quick.
Does An 8% Interest Savings Account Exist?
What would happen if we bumped up the interest rate? Let’s say that you come to one of our Financial Self-Reliance Workshops and discover that, yes, you can get an average of 8% interest on that same $5,000 dollars. What would that look like? Well, eight into 72 equals nine. So your money would double every nine years.
At age 38 you would have $10,000 and at age 47 you would have $20,000. But at this point you’re only 47, you have two more doublings! At age 56 your $20,000 doubles to $40,000 and at age 65 your money has grown to $80,000! So as you can see, a small 4% difference in your interest made a $60,000 difference in
I’ll give you 12% GUARANTEED!!!
But what if I had an account that could guarantee you 12%? No, really! I can guarantee you 12%, contractually and in writing! I think I could even guarantee you 18% or 24%. Where are these fabulous accounts, you ask? Well, you probably already have one or two in your back pocket. That’s right, I’m talking about a credit card. I know, that was mean of me to do. But when you think about it, you are getting a 12% interest rate on your money. It’s just money that you’re spending, not money you’re making. Now, if you’ve forgiven me, let’s take this same rule of 72 and apply it to your consumer debt.
Let’s say that you get yourself a shiny new credit card at age 29 that has an interest rate of 12% (the average going rate of cards right now). And you have that same $5,000, only this time it’s your credit limit. Now, let’s say you go out in the first month and max out that card and you DON’T have the money to pay it off right away. In fact, you plan on just paying the minimum $25 payment until it’s
Now, let’s assume you miss a few payments and it takes you until you’re 65 to pay off this card. Using the rule of 72 (72 divided by 12 equals 6), that $5,000 that you owe would double every six years! So at 35 you would owe $10,000, at 41 that debt would have grown to $20,000, at 47 it’s $40,000, at 53 you’ve grown it to $80,000, at 59 the credit card company is sitting pretty at $160,000, and by 65 the debt you’ve either paid or grown is $320,000! And that’s not even accounting for the jump in interest to 18%, 24%, or even 36% for those payments that you missed!
Earn It Or Pay It
Remember what I said above? Those who understand compound interest earn it and those who don’t pay it. This is why it is so important for us to find ways out of consumer or credit card debt. Even our student loans are killing our ability to save! According to TD Ameritrade, the average person today doesn’t even plan on saving until about 38 when student loans have been paid off (hopefully). In the meantime, the compounding interest on those loans are making it even harder to save and putting us further behind!
So What’s a Person To Do?
Luckily, there are ways out of debt. There are a lot of strategies, gurus, and tools that you can turn to and find help. J&M Creative Solutions offers a FREE Financial Self-Reliance workshop (mentioned above) that helps you to create a budget and get out of debt faster. We will also help you find those high interest, high growth accounts that keep your savings safe from a market downturn. We work with groups and one on one with people and we NEVER charge a fee for our services. As I’ve promised before, we are a NO FEE-based company and we only work with NO FEE-based accounts. Feel free to schedule your FREE appointment today and discover how we can turn compound interest from being your taskmaster to your employee!
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