What if I told you that the same thing that can make you wealthy and financially secure is the same thing that could keep you deep in the trenches of debt?
You see, interest can either be a powerful force of good or a source of evil. Interest can help you build wealth or it can cost you a lot of money. It all depends on which side of the coin you are on.
What is interest?
In lending terms, interest is a percentage of money that a lender charges the borrower for the convenience of accessing money. So if you take out a car loan, student loan or rack up credit card debt — you’ll be paying interest on that loan. And the higher the interest rate, the more you’ll be paying.
On the other hand, in terms of saving and investing, interest is a good thing. For example, if you open a savings account, you can typically earn interest on your deposits. In essence, you’re earning more money on top of your principal balance.
Interest on its own can earn you money or cost you money, but there’s one specific type of interest that can create magic or wreak havoc: compound interest.
What is compound interest?
So what is compound interest exactly? According to Investopedia, “Compound interest (or compounding interest) is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan.”
Essentially, compound interest is earning interest on interest, and is one of the magic ingredients to building wealth — or what can keep you deep in debt.
Albert Einstein has been quoted saying, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.”
In other words, are you using compound interest to your advantage? Or getting sucked into a trap of debt filled with interest trying to get out?
How you can build wealth with compound interest
Compound interest is one of those concepts that you might get intellectually, but it’s hard to grasp how it really affects you and your financial life. That is, until you look at the math.
Here’s a powerful example from Get Rich Slowly:
“If 20-year-old Britney makes a one-time $5,000 contribution to her Roth IRA and earns an average 8 percent annual return, and if she never touches the money, that $5,000 will grow to just under $180,000 by the time she retires at age 65”
“How is that even possible?!,” you might wonder. With a single investment and return, your money will grow. Then you’ll earn more money on that larger balance too. As your investments grow, so does the interest you earn.
Compound interest is a powerful vehicle for wealth-building. Utilizing the power of time and starting early, you can truly use this concept to your advantage. Unfortunately, many people are stuck in the cycle of debt and getting hit with compound interest in a negative way and ultimately paying far more than they initially borrowed.
How compound interest can cost you
Compound interest is a way credit card companies can earn big returns on the balance you carry. Even if it’s a fairly small amount.
Don’t believe me? Check out this example from Business Insider:
“On the debt side of things, how much does your credit card company earn if you carry just an average of a $5,000 credit card balance, paying, say, 22% annual interest rate (compounding monthly) for the next 10 years?”
Have any guesses? The answer may just shock you. According to Business Insider’s calculation, a mere $5,000 credit card balance with a 22 percent APR compounded monthly for 10 years will turn into a total of $44,235.
That’s nearly nine times your original balance! This is how credit card interest can really cost you over time.
It’s the hurdle that can make getting out of credit card debt a tough battle, and can make your original (small) balance a fairly large sum of money.
It’s up to you
Debt is a national pastime it seems, and whether people know it or not, they’re dealing with compound interest every day. But you can also use this powerful concept in your favor.
Instead of being stuck in debt, you can build wealth and earn more money with very little effort because of compound interest.
So next time you want to carry a balance on your credit card, think of how much it’s really costing you. Then, ask yourself — “How much will this be worth in 30 years if I invest this instead?”
Making this mental shift can help you use compound interest and make it work for you instead of against you.