Understanding compound interest: what they don’t teach you in school.
A Wall Street Journal blogger mentions that bad math can lead to costly money mistakes. The mistake is not taking into account the effects of compound interest.
Compound interest is one of the most powerful ways in which saving and investing can help you reach financial independence. In short, compound interest is interest on interest. Compound interest is when your money works for you, instead of you working for money.Here’s an example of how compound interest works. Suppose you have a $1000 emergency fund in an ING high-yield savings account earning 4% interest annually. After one year you would earn $40 in interest. Easy right? Now suppose you leave it in there for another year, how much interest would your account earn? If you said $41.60 you are correct. You see, the $40 that you earned last year was working for you, and enabled you to gain an additional $1.60. I know it doesn’t sound like much, but suppose you paid off all of your debt and managed to save $100,000. Now your interest will net you $160. And that’s only the second year. Every year you keep that money in there, the amount of compound interest will go up. Also keep in mind that most banks compound interest daily, so you will earn slightly more interest than simple annual interest.
Of course compound interest can work in reverse. If you don’t pay your interest charges in full that amount will be tacked onto the balance, which will lead to higher interest charges and corresponding higher payments. Unfortunately nasty products like negative amortization mortgages make it easy to pay reduced payments and allow interest to accumulate on your loan. Never take one of these loans out, it’s only good for one person, and that’s the one getting paid the extra interest.
One of my biggest questions is why topics like this are not covered more in depth during high school? I know trigonometry is important, as is reading Beowulf and learning geography. But this is practical knowledge that kids will need to know for the rest of their lives. How much more might new workers save for retirement if they knew that their money would make them even more money with no additional work? The author of the study remarks that people don’t ask tough questions because they don’t want to seem naive. I would argue that many people have no clue about how compound interest works and wouldn’t even think to ask about it. But if you’re reading this you now know a little bit more about what compound interest is and how it works.
If you’re interested in the math behind compound interest, check out the Wikipedia entry. Or, if you want a simple calculator to give you an idea of how much an initial lump sum can grow, take a look at MoneyChimp.com’s Compound Interest Calculator. And as always, if you have any questions feel free to contact me at my email Rich@FreeFromMoney.net.
