Personal Finance Concepts You Should Know – Concept 1: Compound Interest

River1Many people leave home without knowing many key personal finance concepts.  This may because their parents don’t understand them themselves, or maybe because finances are not discussed at home because they are considered private matters.Unfortunately this leads to bad decisions about money, which leads to financial insecurity, debt, and even divorce and health problems.

Today we’ll tackle the first key personal finance concept you should understand:

Compound interest:  Compound interest is the way money grows when interest earned by the money in turn earns interest.  Rather than earning $10 each year from an investment, you earn $10 the first year, then $11 the next year because you’re earning interest on the interest earned during the first year, then maybe $13 the third year, and so on.  Each year the amount earned from interest on interest grows.

If you have compound interest working for you it is a wonderful thing.  If you divide 72 by the interest rate you are earning, you can predict how long it will take your money to double.  For example, if you have money invested at 2% per year, it will way 36 years to double (72/2 = 36 years).  If you have it invested at 12%, it will only take 6 years (72/12 = 6 years).

Another thing about compound interest is that the amount you get in interest at the end is far more than you receive at the beginning.  You will be lucky to earn a couple of hundred dollars in your 401k from investment returns during the first years.  By the time you are about to retire, however, you might be making a half million dollars per year in returns.  The difference is that at the beginning you only have a couple of thousand dollars earning interest.  At the end, you’re earning interest on millions of dollars, much of it generated by investments from the past years.   Interest earning interest.

When you have compound interest working against you, it is just the opposite.  When you take out a home loan, you will pay much more interest at the start than you will at the end.  With a 30-year loan, you will typically not pay off half of the home loan principle until you have been paying for over 20 years.  Instead, most of your money will be going to interest for those first years.  In fact, during the first few months more than 90% of your payment may go to interest.  During the last few months, almost all of your payment will go to pay down the principle.

It therefore matters most in the beginning to both limit the amount you owe and to pay as much as you can.  If you pay just one extra payment per year during the first half of a loan, you can cut your payment time down my nine years or more and save hundreds of thousands of dollars in interest.  Think about how much money you pay out during those last nine years at $1000 per month – that’s $12,000 per year or $108,000 over 9 years.  If you pay an extra payment a year for the first 15 years (just $15,000), you’ll save all of that money.  Likewise, if you take out a $100,000 loan instead of a $200,000 loan because you buy a cheaper house or put down a bigger down payment, you’ll save all that money on interest.  You also save a lot by getting a 15-year loan instead of a 30-year loan, both because you’ll be paying interest for less time and because your loan rate will be less.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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