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It is said that when Albert Einstein was asked what the most powerful force in the universe was he simply replied “compound interest.” This coming from the guy who developed the general theory of relativity, along with 300 published scientific works. I was humbled by the thought, regardless if Einstein actually said this or not because compound interest is indeed powerful enough to affect the lives of every person on Earth. Perhaps it took a name like Albert Einstein to remind us how critical this topic is.
However, much to my dismay, many people actively participate in agreements and make financial plans for their life without understanding what compound interest really means. I am talking about car loans, retirement plans, mortgages, student loans, annuities and many other financially based products that play a role in our lives everyday. The resulting financial decisions end up negatively affecting quality of life either now, or in the future of that person. By learning about the power of compounding interest a person can learn to make better decisions about their money and their responsibilities. College students can especially benefit from mastering this concept because they can avoid financial entanglements early and set themselves up for success in the future.
So what is “interest”? – Interest is the cost associated with borrowing or lending money. It can be considered a fee on borrowed assets. When lending money, banks apply an interest rate to the loan so that the amount repaid is greater than what was originally lent, creating a profit. A loan will have an annual percentage rate (APR) to explain the interest cost of this loan in one year.
Generally, it is the interest rate of a loan that determines the total cost to the consumer. A high interest rate loan will cost more to repay than a low interest rate loan, all things being equal. Therefore it behooves borrowers to search for a loan with a low rate in order to reduce the costs of repayment. Here is an example to compare.
Bobby borrows $10,000 with an APR of 5 percent. The loan begins repayment immediately with a 10 year monthly payment schedule of $106.07. At the end of 10 years, Bobby pays back $12,727.70. The additional $2,727.70 paid to the bank is the bank’s “profit” from providing the loan.
Annie borrows $10,000 with an APR of 10 percent. The loan begins repayment immediately with a 10 year monthly payment schedule of $132.15. At the end of 10 years, Annie pays back $15,858.15. The additional $5,858.15 paid to the bank is considered the “profit”.
The interest rate for Annie was twice what Bobby had but Annie ended up repaying more than twice the interest cost of Bobby.
So what about “Compounding Interest?” – Compounding interest is when any interest accrued on a loan is added to the outstanding principal amount borrowed. This amount added to the principal begins to accrue interest immediately.
Consider an example of a bank account with interest compounded every year at 20%. An account with $1000 initial principal would have a balance of $1200 at the end of the first year. In the following year, that $1200 would grow another 20% to $1440. In the third year $1440 would grow to $1,728 and so on.
Taking control of compounding interest – Many people have their first encounter with compounding interest when using credit cards. The debts on a credit card can quickly stack up if not paid off quickly and aggressively. The same thing holds true with student loans. The interest rate on student loans is typically lower than a credit card, but the volume of money borrowed for student loans means that debts can add up quickly as well. It is recommended to follow aggressive repayment of student loans to eliminate the debt quickly. The following three examples are of student loan repayment plans for your comparison. Please note the major differences of cost.
Paul A. borrows a private student loan for $10,000 for each of his four years of college. They each have a 7% rate. Paul elects to not make any payments towards this loan until after graduation. Upon graduation, the loans enter repayment with a total outstanding balance of $44,399.43. This will require a monthly payment of $515.52 every month for the next 10 years to complete repayment. The total amount repaid is $61,862.40.
Ryan B. borrows a private student loan for $10,000 for each of his four years of college. They each have a 7% rate. Ryan elects to begin loan repayment while in school. As soon as the loan disburses he begins making payments of $116.11 a month. Upon graduation the total outstanding loan debt is $39,912.85. This will require a monthly payment of $463.42 for the next 10 years to complete repayment. The total amount repaid is $55,610.65.
Rob C. borrows a private student loan for $10,000 for each of his four years of college. They each have a 7% rate. Ryan pays $116.11 plus an additional $100 for a total monthly payment of $216.11. Upon graduation the total outstanding debt is $35,849.02. This will require monthly payments of $416.24 over the next ten years to complete repayment. The total amount repaid is $49,948.50.
The Phrase that pays – The above examples lead to one conclusion; “Pay a little now and save a lot later”. Each one of the examples has the exact same loan amount and interest rate and period of repayment. The only thing that is different is the repayment schedule each student follows. Because Paul A. decides not to make any payments towards his loans while in school, it ends up costing much more to repay in the long run. That is a direct result of the power of compounding interest further increasing debts left unchecked. Because Ryan B. makes payments while in school, his loan costs $6251.90 less to repay than Paul. Rob C’s aggressive repayment plan saves him $11,913.90 over the original cost of the loan and puts him in the best position for debt freedom. If Rob continued to accelerate his repayment he could get out of debt even faster.
In each one of these scenarios, the power of compounding interest was in place to allow for debts to increase. It was the reaction of each of these students that dictated the outcome of repayment. By getting pro-active with repayment, a borrower can mitigate the expansion of debt to an unmanageable amount. If a student chooses not to make payments while in school, they should recognize that compound interest will force that debt to increase and cost much for repayment later. The wise move is to counter the impact of compounding interest by beginning loan repayment immediately, and adding additional accelerating payments if possible.
Getting compound interest to work for you – The true power of compound interest is found in simplicity and applicability; Simplicity, because of the basic nature of the concept and applicability because of the many people that partake in its use everyday. However for the most part, interaction with compounding interest only comes in situations where we owe debt like for houses, cars and school. The great thing is getting compounding interest to work for you. This is where the power of saving money is so important. In Rob C’s example he was able to save $11,913.90 from loan interest payments. If Rob C. saves this money at an average annual return of 7% he would have $23,942.96 at the end of 10 years.
In this economy, every dollar counts. Your goal should be to eliminate debt as quickly as possible and build personal savings to harness the power of compounding interest for yourself. Letting debts grow out of control early is a sure way to eliminate wealth building in the future.
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