You have to make a basic decision about your finances: Will money work for you or against you? The way you manage it can bring prosperity or drag you down into financial bondage. We’ll talk about that first on MoneyWise.
- Proverbs 22:7: “The rich rules over the poor, and the borrower is the slave of the lender.”
- Now, we all know that’s true, but today we want to drill down a bit into exactly how money can make you a slave and how you can prevent that from happening. It’s all about compound interest, which Einstein once called “the 8th wonder of the world.”
- And like many wonders, it seems there’s still some mystery about compound interest.
- THE POWER OF COMPOUNDING
- A recent financial literacy survey found that individuals who fail to grasp this concept have higher transaction fees, run up more debt, and pay higher interest rates on credit cards and other loans. “Compound” means that two things are added together, in this case, principal and interest.
- And here’s how compound interest can be either a financial blessing or a curse. It works the same for both savings and debt. In very simple terms, compound interest means that your savings account — or your debt — will grow quickly.
- It’s calculated on your principal amount, plus your accumulated interest. So the total amount you pay — or receive in the case of a savings account — will change. It grows over time. Compound interest either accrues or pays interest on top of interest, and that’s how it grows so fast.
- It also makes it a double-edged sword. Compound interest works for you if you’re saving money but against you if you’re borrowing.
- Let’s use the example of a credit card. Say you have a $6,000 balance, and we’ll use a compound interest rate of 17-percent, which may even be a bit low these days.
- Now, assuming you’re paying only the minimum amount due each month, after five years your $6,000 balance will grow to $9,000 because you’ve accumulated almost $3,000 in interest.
- After 10 years your balance will be $15,500 because you’ve added an additional $6,500 in interest. At that point, you actually owe more in interest alone than you did with your original principal.
- And it gets even scarier, after 15 years your balance is a whopping $26,000! That’s how compound interest works against you, and that’s how the borrower becomes slave to the lender, especially in the case of today’s rising interest rates.
- But compound interest works in your favor when you become the lender. That’s what you’re doing when you put money in a savings account. You’re loaning money to the bank. And just as rising interest rates hurt you as a borrower, they make your money work even harder for you when you save.
- Let’s use the same amount we started with in our credit card example: $6,000, but flip it around. You put that amount in your savings account earning 1.2% interest, which is even a bit low these days with online accounts. And you make no additional deposits or withdrawals.
- After five years, at even that low rate, you’ve earned almost $400 because of compound interest. Each month your principal grows, and you’re paid even more interest on that higher amount.
- After 10 years you’ve accumulated nearly $1,000 in interest. And after 15 years you’ve earned about $1,500 in interest.
- Again, you have to make a decision whether compound interest will work for you or against you.
- MAKE COMPOUND INTEREST WORK FOR YOU
- Obviously, you want it to work for you. That means never carrying a balance on credit cards. Pay off the entire balance each month. Also, pay off other consumer loans as quickly as possible, making additional payments on the principal if you can.
- You also need to start saving. And the first place is with your emergency fund to eliminate the need to use credit. Start by saving $1500. Keep going until you have one month’s worth of expenses saved. Eventually you want 3 to 6 months worth in your emergency fund.
- Keep that in a higher interest online account. They give you a better rate than brick and mortar banks. We like Ally Bank, Marcus and Capital One 360 to name a few. They’re very safe and carry FDIC insurance up to $250,000.
- Do those things and you’ll put your money to work for you, not against you.
On this program, Rob also answers listener questions:
- How do you select the best mortgage for a home purchase?
- How can you help young adult children to build credit without taking on debt?
- Should you consider working with a company that offers cash in exchange for a percentage of your home’s future value?
- How do you go about finding a good used car?
Remember, you can call in to ask your questions most days at (800) 525-7000 or email them to Questions@MoneyWise.org. Also, visit our website at MoneyWise.org where you can connect with a MoneyWise Coach, join the MoneyWise Community, and even download the free MoneyWise app.