"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."
What is compound interest, why is it so important, and is that THE Albert Einstein? The answer to the third question is yes. In addition to contemplating the laws of the universe, the world’s most famous theoretical physicist was also keenly aware of the most powerful force in the financial world.
When you borrow money the amount you borrow is called principal and you pay an interest rate to compensate the lender for providing the loan. Interest rates are generally presented as an annual percentage rate. As a result, multiple factors affect how much interest you will ultimately pay. The primary factors are the interest rate, the amount of principal, the length of the loan, and how frequently the interest is compounded. The first two factors, the interest rate and principal amount, are generally out of your control; you know how much you need to borrow and the lender sets the interest rate. Therefore, we’ll focus on the latter two: the length of the loan and the compounding frequency.
Let’s imagine a 10-year $10,000 loan with a 5% interest rate compounded annually. To put the "compound" in compound interest, and for the sake of keeping the math simple, we’ll assume that you aren’t required to make any payments until the loan is due. Instead the interest is added to the principal at the end of every year and this new amount is used to calculate the interest for the next year. In 10 years the lender will ask for $16,288.95; repayment of the original $10,000 as well as $6,288.95 in interest. What if we extend this same loan out to 20 years? Although the length of the loan doubled, the amount of interest owed nearly triples to $16,532.98.
At this point you should have a good understanding of the power of compound interest. Now you can use this knowledge in your favor to minimize the amount of interest that you pay over the life of any loan. Here are some simple, effective tricks:
- Make one extra mortgage payment each January. This alone will turn a 30-year mortgage (at a 5% interest rate) into a 25-year mortgage! If you are paying more than 5% interest, making an extra payment would shorten the mortgage further.
- Round up your payment to the nearest $100 or more if you can swing it. These small extra principal payments add up over time and can significantly lower the interest charges.
- Pay your mortgage bi-weekly if the lender allows it. By paying half the amount 2 weeks early, the interest charges over the term of the loan will be reduced significantly.
The above examples use a mortgage loan as an example because prepayment penalties on mortgages are rare in the U.S. We recommend seeking loans with no prepayment penalties if possible, and contacting your lender prior to making prepayments on any existing loans. As you formulate a strategy for reducing debt, remember that every little bit counts. Any payments in excess of the interest due is credited to the principal and will reduce the amount of interest that accrues in the future. If you can’t swing one of the above, or need to take a break due to a tight budget, don’t sweat it…just do what you can whenever you can.
A final note: Compounding can work for you as well. To the critical reader this article not only presented important debt management concepts but illustrated how lucratice being a lender can be!
Stay tuned for next week's investing concept during Financial Literacy month.
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