Do you know the power of compound interest in its entirety? It’s the greatest thing in the world -when it’s working for you.
When it’s working against you, it can be one of the most devastating things in the world.
Here it is – the good and the bad of compound interest!
The good - why compound interest is powerful
Many people think that if you have $100,000 and you get a 6% annual return, compounded over 30 years, you’re left with $106,000. Not exactly.
It would actually be over half a million dollars. Crazy, right? That’s compound interest for you.
So what happens exactly?
Interest generally compounds annually, so that means you earn 6% on your principle.
Keeping with the above example, the first year your principle is $100,000, but at the end of that year, you earn 6%.
So that means the second year you’ll be earning 6% on $106,000.
Of course, this is an oversimplified example and it’s next to impossible to find a 6% return on your investment that stays at exactly 6% for 30 years, but it does make it a whole lot easier to explain.
Here are a few ways compound interest can be your greatest ally:
- Investing – Just like in the above example, compound interest, over time, can lead to extraordinary results. You continue to earn interest on your money and it continues to grow as it compounds. That’s why a one-time contribution of $100,000 could easily grow to several times that over your life span.
- Early Debt Reduction – By paying extra on your loans, early-on in the term, you will reduce your interest bill by a tonne. In fact, with your mortgage, making a few extra payments in the beginning can knock years off the length of the loan.
The bad - compound interest as an enemy
Just like compound interest works for you, it can work against you (which means it’s working for somebody else).
When you’re investing, it’s nice to know that your interest compounds annually, when you’re in debt, it’s terrible to know that your interest compounds annually.
This means that you pay your APR (Annual Percentage Rate) every year, based on the remaining balance. So if you owe $10,000 on your car and you have a 14% interest rate, you pay 14% of $10,000 the first year.
After that you pay 14% of the remaining balance each year.
Of course that amount is divided over your monthly payments.
This is why, if you have ever looked at your mortgage annuitisation schedule, you may have noticed that during the first few years, the majority of your payment is going to interest.
That’s terrible if you’re paying your regular minimum payment, but if you pay extra, you can take a huge chunk out during the early years.
Here are a few ways compound interest can be your worst enemy:
- Mortgage – The typical mortgage in Australia is 30 years. That means that even a low interest rate of 2% or 3% can be well over $100,000 paid in interest over a 30-year period.
- Consumer Debt – Credit cards and car loans are the two most popular forms of consumer debt and two of the most likely to have a high interest rate. The higher the interest rate, the more each percentage matters.
In other words, there is a bigger difference between 14% and 15% than there is between 2% and 3%.
The fine line between investing and paying off debt
Many people think it’s not worth your time to pay off your mortgage early since you can get a better return by investing the money.
In other words, you can earn more by investing than you would save by paying off your mortgage early.
Obviously this depends on both interest rates.
So where is the line between paying off debt and investing the money?
It’s definitely a grey area!
There’s no magic number, but when you can consistently earn more by investing than you save by paying off your debt, it’s at least worth considering.
Just make sure you account for any taxes you may have to pay on capital gains if your investing in a taxable account.
Remember the power of compound interest and make sure it’s working for you, not against you.
For more property tips in plain English, visit the blog section of the Naked Real Estate website.