First Person: A Compound Interest Primer

While there were many useful things that I took away from my college education, there was a seemingly insignificant tidbit of information that turned out to be one of the most useful and beneficial items I absorbed during my college career. This tiny bit of knowledge was the ability to determine and calculate compound interest.

Understanding compound interest and how it applies to various situations has probably saved me tens of thousands of dollars in the decade following my college graduation. These savings have come not just from understanding the formula to calculate a debt related scenario or using it to determine future returns upon an investment, but by truly understanding the ramifications compound interest can play over the course of time in the undertaking of debt or the investment of money.

Compound Interest

Most people have a general understanding of the concept of compound interest and what it can do, and in reality, that's all many of us need in order to make a huge difference in the way we conduct our personal financial affairs. However, I think that when it comes to understanding the actual power of compound interest and the significant difference it can make in our financial lives, and this is where many people have a general failure to fully comprehend its power.

When you're dealing with compound interest, it's probably easier to provide an actual example than try to explain with words what it means. Here is a simple example of a 6% interest rate being applied to an investment of $1,000 each year over a period of five years, versus the same interest rate being compounded, meaning the interest is earning interest upon itself, not just the initial investment amount.

6% Interest Rate

Year 1 - $1000 + $60 = $1060

Year 2 - $1060 + $60 = $1120

Year 3 - $1120 + $60 = $1180

Year 4 - $1180 + $60 = $1240

Year 5 - $1240 + $60 = $1300

vs.

6% Compounded Interest Rate

Year 1 - $1000 + $60 = $1060

Year 2 - $1060 + $63.60 = $1123.60

Year 3 - $1123.60 + $67.42 = $1191.02

Year 4 - $1191.02 + $71.46 = $1262.48

Year 5 - $1262.48 + $75.75 = $1338.23

You might be saying to yourself: "A whole $38 bucks difference over the course of five years? Big deal." But if you put this example into the context of buying a home or paying interest on a credit card at a 20% interest rate, then it is a big deal.

Credit Cards

Personally, I don't really use credit cards that often, and I've yet to pay a dime in interest on any credit card balance. I don't like giving my hard-earned money to greedy banks just for the heck of it. But let's get to our compound interest example and how it can affect the amount you pay on your credit card balance if you choose to carry one.

For our example, we'll say that you carry an annual average balance of $1000. You have two credit cards from which to choose to carry that balance; one with a 10% annual interest rate, and the other with a 15% interest rate. Let's see what the difference in compound interest between the two cards would be in sustaining such a balance over a period of five years.

Card #1 - 10%
Year 1 - $1000 + $100 = $1100

Year 2 - $1100 + $110 = $1210

Year 3 - $1210 + $121 = $1331

Year 4 - $1331 + $133.10 = $1464.10

Year 5 - $1464.10 + $146.41 = $1610.51

Card #2 - 15%
Year 1 - $1000 + $150 = $1150

Year 2 - $1150 + $172.50 = $1322.50

Year 3 - $1322.50 + $198.38 = $1520.88

Year 4 - $1520.88 + $228.13 = $1749.01

Year 5 - $1749.01 + $262.35 = $2011.36

As you can see, the difference between the card with a 10% rate and a 15% rate is just over $400 over a period of five years. And as I recall, the average debt carrying consumer has a balance somewhere closer to $10,000, so you can see just how big a difference the rate on the card you carry can make.

Home & Car Payments

It wasn't until I actually undertook buying a home with an attached mortgage that I fully understood just how big of a difference compound interest can make in recognizing value in real estate over the course of time.

There were three things that I quickly realized could make a huge difference in the amount of interest I had to pay to the bank over the course of the mortgage. These three things are the building blocks of compound interest -- time, interest rate, and the number of payments or reduction thereof. Understanding this alone has probably saved me thousands of dollars in just the first few years of my mortgage.

Let me give you an example of what I'm talking about.

Let's say you want to take out a $200,000 mortgage but are unsure as to the duration at which you should lock in -- whether to go for a 15 or 30-year term. For our example, let's say you can lock in a 15-year mortgage at a fixed rate of 5% while a 30-year mortgage would be at a fixed rate of 6%. Doesn't seem like much of a difference, but consider that you are not only paying a lesser rate on the 15-year mortgage, but you are paying over a lesser period of time, which as we've seen, can certainly affect how much interest compounds on your loan. Given, your payments will be larger, but the long-term outcome could be well worth the short-term suffering.

Let's take a look at the difference between the two options.

The $200,000, 30-year fixed rate mortgage @ 6% (not including lender fees and all other hullabaloo that goes along with getting a mortgage), and not factoring in property taxes, insurance, tax credits, etc. will have monthly payments at around $1199.10 and therefore will cost you by the end of your loan payment period, a total of about: $431,676.00 (The $200,000 loan + $231,676.38 in compound interest).

Meanwhile, the $200,000, 15-year fixed rate mortgage @ 5% (also not including lender fees and all the rest) will leave monthly payments at around $1581.59 and cost you by the end of your loan payment period, a total of: $284,686.20 (The $200,000 + $84.686.20 in compound interest).

Big difference -- actually, a difference to the tune of almost $147,000! And that doesn't even include the option of making extra payments along the way, which could save you thousands more. If you'd like to play around a bit with your mortgage options, consider giving an online mortgage calculator a try. It's a quick and easy way to find out just how much money you can save on a home loan.

Investments

You can see how significant the difference between different compound interest rates and various timeframes can be, so you can imagine the same would hold true when it comes to making money through investments. Of course you probably won't have to make decisions between interest rates of 10% and 15% on your savings account, certificates of deposit or savings bonds, as you might with your credit card rates. Still, finding the difference between an investment vehicle offering 1.5% and one offering 3% over the next five years, even though it might not seem like a big deal, can make a significant difference in how much money you make.

So I hope this brief overview of compound interest has helped and made sense. It can certainly be worth your time to sit down and figure out the difference in compound interest terms on your various debts and investments. Even if you don't have a financial calculator like I do, you can still figure it long hand or do a quick Internet search for a compound interest calculator to help you save yourself a quick bit of money.

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Disclaimer: The author is not a licensed financial professional. The information provided in this article is for informational purposes only and does not constitute legal or financial advice. For financial advice, readers should consult a licensed financial advisor. Any action taken by the reader due to the information provided in this article is solely at the reader's discretion. All calculations in this article have not been confirmed or varified by a licensed financial professional.