What you should know about money.

“Oh no!” You might be groaning to yourself. “What is she going on about now.” Actually, I’m going to go on about compound interest.

Bear with me. This won’t take long to read and you might save yourself a bunch of money (and I included photos to keep it fascinating). As a bonus, if you read to the very end I show you how to get $15,000 in free money! Wow. So, read on my friends.

If you use a credit card, have a mortgage, or are otherwise involved with borrowing or investing money, then you should have an understanding of compound interest. It’s how the rich get richer and the poor go broke.

Here is how it works: When you borrow money you pay it back with interest. Interest is simply the amount of money (usually a % of the total loan) that the lender charges you for allowing you to borrow that money. Or, in the case of an investment, it is what the institution pays you for letting them use the money you have invested (deposited) with them.

When the interest is compounded it means that the interest you owe each month (or quarter or year, depending on how often it is compounded) is added to the total you owe. This means you are paying interest on the interest.

There are set formulas to determine the math and different companies do things a little differently. Often loans are arranged so the monthly payments are all the same. In the case of a mortgage it is usually set up so you pay more of the the interest in the beginning and only after the bank has gotten a good portion of the interest do you start paying the the principle of the loan. In each case, however you end up doling it out, the interest will accumulate, that is, it will compound.

For example, say you have $1000 in a bank account earning 5% interest each year (unlikely, but the math is a lot easier than 1.46%). If it is a flat 5% rate, at the end of the year you will have $1050. Pretty straightforward.

If the interest is compounded monthly then it gets more complicated – but if you are the investor it is well worth it.

Using the same example of $1000 over a year at 5%, in the first month you get 1/12 (one month’s worth) of the yearly interest. That is $50 per year, divided by 12 months, or $4.17.

So, $4.17 is added to your balance. Now, in your second month you have 1004.17 in your account. Again you get 1/12 of the yearly interest. But now that is 5% of $1004.17 so your monthly interest is now $4.18. The third month you are getting paid 5% of 1004.18, so your 4th month you will be getting interest on a bit more than the third month. By the end of your first year you will have earned $1051.20.

Big deal, you might be thinking grumpily to yourself. I have to read all this for a measly $1.20 a year.

Yes, but not so fast.

cherry and walnut box — hey, I’m a woodworker, why not a photo of a box? box by creative woodworking

Now lets look at your credit card. A credit card is simply an easy way to borrow money. You hand over the plastic, some bank somewhere coughs up the payment and you walk happily away clutching your widget under your arm. Unfortunately, at some point you need to pay the piper/banker.

Say you owe $1000 on your card at 20% interest (much more realistic than the 5% at the bank). First you need to know if that 20% is the interest rate alone, or the APR (Annual Percentage Rate). The APR includes all that compounding, so it is a more realistic number. Credit cards have to tell you the APR. Look for it on your card and see what you are paying.

If you have a flat 20% rate (you don’t), by the end of the first year you will owe $1200 ($200 = 20% of $1000). If your credit company compounds the interest monthly (likely) then it works the same as it did with your bank account, only less happily for your financial well being.

The first month you will owe $16.67 in interest ($200 interest per year divided by 12 months). This gets added to your balance. You now owe 1016.67 total. The next month you will owe a total of $1084.72, because of the interest added to your original balance. By the end of the year you will owe $1219.39, for an APR of 21.94%. So, by compounding your interest, 20% turns into 21.94%.

In that scenario, for ever $78.06 you spend you are handing over $100. That $21.94 of each $100 is what you pay for the privilege of borrowing the money (ie using your credit card). People with low incomes or a bad credit record end up paying higher interest rates. It becomes harder to borrow and the loans get harder to pay off. This is a recipe for going broke.

On the other hand, if you can pay off your card every month you are paying $100 for every $100 you borrow. In that case the annual fee (if there is one) is the only money you are actually paying the credit card company. Now that is a good deal. It doesn’t get much better than a 0% loan.

If you can’t pay off your credit card it can quickly add up. That is because credit card rates are so high and often if you are late on a payment they go even higher.

But even at low rates compound interest adds up, all it takes is time. This is how the rich get richer.

Say you have $100,000 lying around that you invest at 3.92% APR. In 30 years you will have $170,213. You will have “earned” $70,213. Those numbers are actually for a mortgage, but it works the same way whether you are borrowing or investing (although the difference to your purse is considerable). So, if you flip to being the borrower, then in this example, the bank will have charged you $70,213 for your mortgage. Remember, that is at 3.92% while credit cards can easily be 15-30%.

But here is the promising part.

Say you can put away $50 each month starting when you are 30. In those same 30 years, at the same 3.92% you will save $33,204.28. Not bad, considering that the amount you actually invested was $18,000 ($50/month = $600/year x 30 years = $18,000). That is the real magic of compound interest. It grows faster and faster over time as your money snowballs. It is much better for your finances if you invest the money rather than borrow it!

So, I recommend you pay off your loans and start putting money away.