As Albert Einstein once said, "the power of compound interest is the most powerful force in the universe." He goes on to add that, “compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it." These two statements are right on the money. Compound interest is so effective, that virtually nothing can stop it once it’s on cruise control. If you don’t understand what compound interest is, you’re more than likely paying it.
What is Compound Interest?
According to Investopedia, compound interest “is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan” (Segal "Compound Interest"). In other words, compound interest is money that grows on top of money. Think of compound interest as a balloon that continues to grow as you fill it up with air. Not to blow your mind, but as the air goes in one balloon, another balloon is created (from the original balloon) and the cycle continues as more air goes into each balloon. We’ll get into the details later, but keep that picture in mind.
Applying the Principle of Compound Interest
Hopefully the balloon example didn’t confuse you, but if it did, there’s still hope. There are many ways to take advantage of compound interest. One way is to not pay off little to no interest loans early such as interest-free loans, credit cards in the interest-free period, etc. Instead you put that “extra” money into an investment that yields a higher return than the interest rate you’re paying on the loan. Now compound (multiply) that by how many years the loan will last and you’ll notice a huge chunk of extra cash that you didn’t know existed.
Let’s try an example. WARNING: This example should only be executed by those disciplined enough to manage credit responsibly. Let’s say you go out and get a credit card with a 0% interest rate for 15 months. You use the card responsibly for necessary purchases and only necessary purchases (i.e. not on a new pair of Jordans). Key word, necessary. Instead of paying off the card completely each month, you decide to invest a portion of this money into something profitable such as the stock market. Let’s say the company you invest in has yielded a 6% annual rate of return off dividends alone! So far, your 6% return is far greater than the 0% you’re paying. So you’re winning already. Ironically, you maintain a balance on the card to the point where you’re at a 29% utilization rate (experts recommend staying below 30% utilization). For more information on credit scores, check out my article titled “The Art of Credit.” I fell in love with this strategy so much that I stayed above 30% for a while, which was not good for my credit score. Now I stay right below 30% as the experts recommend. It is generally a good idea to have a credit card that has no balance on it at all times to give yourself some wiggle room in case you get too “compound interest happy.”
You should never close a credit card account! If you do, your available credit will be gone from that card, which will only increase your utilization rate. Wait there’s more. As the interest-free period (also known as the sweet spot period) is approaching an end, you apply for a low-interest personal loan (or transfer the balance to a new 0% intro rate credit card) if you have good credit and use those funds to clear any balance on the card. Now invest that money that you would’ve used to pay off the credit card at a rate of return higher than the interest rate on the new loan. If you can’t get a good rate, you simply pay off the card with your own cash. This process requires a ton of discipline and I’ve been using this strategy for over a year now. Using OPM or “Other People’s Money” is one of the most effective ways to build wealth. The money you would’ve accumulated from that example alone would be pretty outstanding.
Let’s look at another example from a pure compound interest perspective. There’s a site out there called “Lending Club” where you can lend money to everyday people at a stated interest rate. You receive both principal and interest payments each and every month. Your principal and interest accumulated over time can be reinvested into other loans to ultimately have more money invested. Some of these loans pay as high as 30% interest! Using the rule of 72, it would only take you about two and a half years to recover your initial investment. That’s the power of compound interest.
Now let’s look at it from the other side. Let’s say you do have a credit card with a high interest rate and a pretty high balance. Remember compound interest? Well, if you maintain that balance, the principle of compound interest will work against you. In other words, you’re now paying compound interest instead of earning it, which will deplete your net worth. Be sure to pay off all your high interest debt as soon as you can if deemed to be feasible.
The last example is one of my favorite and can truly make an impact in someone’s life. Virtually everyone hates student loans, but I don’t think they’re that bad at all. The interest is tax deductible, you made an investment in your education that has hopefully yielded a high rate of return, and you’re building credit at the same time. Wait there’s more. You can use any “extra cash” you were planning to use to pay off the loans each month and invest that money instead at a rate of return higher than the interest rate on the student loan. Another win win scenario.
So that’s compound interest in a nutshell. It is a pretty simple concept, but it takes time to truly understand what it means. It’s simply money that grows on top of money. Ways to take advantage of compound interest is not paying off little to no interest rate loans, reinvesting excess cash flow, and paying off high interest rate loans. Some millionaires became rich off this simple, yet complicated concept. If you have any questions, please feel free to contact me.
Segal, Troy. "Compound Interest." Investopedia. N.p., 09 Mar. 2017. Web. 25 Apr. 2017. <http://www.investopedia.com/terms/c/compoundinterest.asp>.