Be Debt Free
Be Debt Free
I just read somewhere today that “compounding interest is like a sorority girl on Ecstasy. She’ll go both ways, but you get a hell of a lot more out of it when she’s going your way.” I had to crack a smile. While not the most subtle of analogies, it certainly paints a vivid picture of what compounding interest can do to your pocket.
Since defining things never goes out of style (and also out of methodology, let’s not kid ourselves here), what exactly is compound interest? Trusty old Wikipedia tells us that “Compound interest is the concept of adding accumulated interest back to the principal, so that interest is earned on interest from that moment on. The act of declaring interest to be principal is called compounding (i.e. interest is compounded). A loan, for example, may have its interest compounded every month: in this case, a loan with $1000 principal and 1% interest per month would have a balance of $1,010 at the end of the first month.” And the interest for the following month will be calculated on the $1,010, not the original $1,000.
Most people who don’t invest, or who are not interested in financial literacy, think that compound interest is some far-flung concept that has nothing to do with their everyday lives. Of course, as long as they’re carrying a credit card balance, for example, they’re sadly mistaken. You credit card debt accrues under the compounding interest principle. Which means that when you don’t pay your credit card (or pay too little), your interest bill (or finance charges, whatever they call it) is tacked onto your balance, which in turn grows and the total becomes your new principal. Your finance charges for next month will be calculated on the new balance. And that’s only half of the story. The other half is that any fees that you incurred are also added to your balance and will generate interest too. That’s the main reason why you can have a credit card with a $1,000 limit and before you know it your balance is twice that amount.
On the other hand, if you’re debt free, and are investing your money in a relatively safe investment vehicle that is producing a nice return, you’re doing exactly the opposite. Over the long run, your money will grow and you might be surprised how far a $200/month regular investment can take you in a 30 to 40 year horizon. The stock market has averaged returns in the vicinity of 9-11% a year depending on who you ask, and this includes the inevitable bear markets and recessions, for the past several decades. If you don’t want the hassle of actively managing your portfolio, grab an index fund, make sure its expenses are as low as can be, and sock away your money consistently. You’ll be sitting pretty in a few decades.
Not convinced? Here are 2 examples to help you make up your mind:
1. Let’s suppose you’re 20 years old want to have one million dollars in the bank when you retire at age 65. What amount of money would you have to deposit, assuming a 10% return rate, for that ONE SINGLE deposit to make you a millionaire? Amazingly, the answer is $13,719.21!
2. Using an online calculator, I just ran a little simulation for myself. I’m 32; assuming a $200/month savings plan, and a 10% interest rate, I would have $623,015 at age 65!
Ultimately, all you have to realize is that carrying debt is using compounding interest too, but against yourself. It’s about time you get rid of that burden and start using that money to transform your financial future into a much brighter one.
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