Getting to Know Compound Interest

Mon April 15th 2019

“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” - Albert Einstein

"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it." - Albert Einstein

Don't let your debt get you down: Compound interest and you.

Many people have a very hazy understanding of interest. Even adults with car loans, credit cards, and mortgages often don't really know how it works. They just sign on the dotted line, pay what they owe every month, and don't really think about it too much. It's when those payments stop that things can get messy.

Compound interest can make a small, manageable debt into a life-ruining burden. Or it can make relatively small savings grow. And understanding how it works can help you make the most of it.

What is compound interest?

For the uninitiated, compound interest is interest added to the principal of a loan or a deposit, so interest is charged on the higher principal, not the original amount.

So if an initial debt of $1000 is charged interest at 10%, after the first year the debt owed will increase to $1100. The second year it will be $1210, the third year $1331, the fourth year $1474.10…

See how the debt doesn't just increase by $100 a year, it increases by more each time? That's the scary thing about compound interest. It's the reason people end up paying a million dollars for a $500,000 house over twenty-five years. It makes unpaid debts increase exponentially, but can make unspent savings grow too.

When compound interest goes bad.

If you're in debt, compound interest can be a nightmare. A person with unpaid credit card debts, personal loans or fines will be hit with compound interest from all sides, making it seemingly impossible to dig themselves out of a financial hole.

Some recent examples from the IRD highlight this problem. The IRD charges a high interest rate – almost 10% - on unpaid tax. They also charge a 1% penalty for each month the tax is overdue. This adds up to crippling compounded debts. One taxpayer's original GST bill of $365,000 increased to more than $2 million in a short space of time. Even more alarming, the $74 million avoidance debt imposed on accountant John George Russell ballooned to more than $400 million in just over a decade, making it nearly impossible ever to pay off.

Ever increasing debt can mean that any payments simply go towards paying off the interest, without touching the principal. Without drastic measures and much higher payments, compound interest means a debt will just keep growing, without much hope of ever paying it off.

How compound interest can work in your favour.

On the other hand, compound interest is great for those with savings. Term deposits and savings accounts let people make the most of their money. If you have a substantial deposit to invest, and can afford to leave it untouched for a while, you can reap the benefits of compound interest and watch your savings grow – with very little effort on your part.

However, these options are really only beneficial for people without other debt. You're unlikely to get an interest rate on a savings account or term deposit that's high enough to offset the interest you'll pay on your loans. That's why it's better to work on paying off what you owe first.

It's always better to know what your money is doing. Understanding the risks and rewards of compound interest can help you make proactive decisions about your financial future, rather than simply signing on that dotted line.

If you want to make sure you are making the right moves with your money, get in touch now and we'll have a chat.

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