When it comes to personal finance, there are really just a handful of things you need to understand in order to take control of your money.
One of the most important concepts that applies to everyone is compounding, and most Americans are clueless about how it works.
According to a recent report from George Washington University, 66% of Americans don’t understand compound interest — one of the most important factors impacting both your savings and your debt.
But the good news is that you don’t have to be a finance wiz to grasp the idea and make it work in your favor!
Let’s take a look at how compound interest works and how it can help and/or hurt your finances.
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The power of compound interest
One of the most important things to understand about money is that a dollar today is worth more than a dollar tomorrow. The time value of money assumes a dollar now is worth more than a dollar in the future, because of variables such as interest rates and inflation.
If you have $100 and do nothing with it, the value of that money will decline as time goes by. But if you put that $100 into a savings account or other type of investment account, it will start to earn interest, and that $100 will grow into a much bigger sum of money.
How it affects your savings
Compound interest is an extremely powerful force that allows investors to earn exponentially larger gains on their money over time — so, again, the money you save now is worth a lot more than the money you save later.
Here’s a simple example: You invest $1,000 today and earn an annual 5% gain, so $50. That $50 is added to the principal amount of your investment, and then next year, you earn a 5% gain on $1,050, so you earn $102.50. And so on…
This is why the it’s crucial that you start saving as early as possible.
Here’s another example: if a 16-year-old saves $2,000 annually for six years, putting the money into a Roth IRA account, and stops at age 21, he or she would have $1 million by age 65.
This assumes a 9.4% average gain annually, which has been the average return on the stock market since 1926.
So the earlier you start putting money away in a retirement account, the more time it has to earn you a lot more money. If you keep telling yourself you can always save later, and even if you do contribute a lot more later than you would now, that money still wouldn’t have the time to grow like it would if you saved now.
Saving money early — not even often, just early — will still ultimately lead you to bigger wealth at the time of retirement. Imagine if that 16-year-old continued to save way beyond just six years — that sum of money would at least double.
How compound interest impacts your debt
While compound interest is a great thing for your savings and investments, it also impacts your debt.
If you carry a balance on your credit card, the lender applies interest to the total principal amount you owe. Then over time, you will be charged interest not just on that principal, but also on that added interest.
Let’s say you owe $5,000 in credit card debt and your card has a 12% interest rate (the current average in the U.S. for fixed annual percentage rates on credit cards is 12.5%). If you pay it off in three years, you will have spent about $1,000 extra in interest alone.
This is why it’s so important to pay down debt as quickly as possible, because otherwise, you’re wasting a lot of extra money on interest charges.
If you were pay that same credit card debt off in one year, instead of three, you would only pay about $300 extra, since the lender has less time to continue adding interest.
Each lender calculates interest charges differently, but no matter what, credit card interest is bad for your financial life — both now and in the long run.
Compound interest is great for investors and it’s the best tool for you to grow your savings and investments over time. The sooner you start putting money away, the longer it has to grow — giving you a bigger sum later in life.
When it comes to credit cards, the best way to avoid wasting money on interest is to make sure you pay your balance in full every month. Only charge what you know you can pay in full that month. It will allow you to develop better spending and saving habits, as well as improve your credit score.