We are so used to thinking of interest as the bad guy. And for good reason. Many of us are paying interest, and when it’s compounded, we are actually paying interest on our interest. When in debt, this situation leads to a rather discouraging state of affairs in which it is difficult to get out from under the debt. However, compound interest isn’t, itself, evil.
Indeed, compound interest, like so many other things in life, is a tool. It all depends on how you use it. In the case of compound interest, it often depends on which side of compound interest you are on. This infographic offers an interesting look at compound interest. (click on the graphic for enhanced details)
You know that interest is just money you pay directly into someone else’s pocket. Interest is the fee you pay in order to be able to borrow money. Lenders want to be able to earn money off the money the provide you, and so charge interest. You aren’t receiving any goods or even any direct services when you pay interest. When you are in debt, you can continue paying interest long after any enjoyment you derived from spending the money is gone.
As you can see from the infographic, there are some moral issues associated with charging excessive interest. However, regardless of what has been written anciently, compound interest — and even usury — have become regular parts of our financial system. And regular parts of our lives.
The infographic also makes an interesting point about how often interest is compounded. When interest is compounded, it is added to your balance. Then, the next time interest is charged, you are charged on your principal, plus the interest charges incurred the last time. One of the reasons credit card debt is such a pain is that many cards compound interest daily. This means that your balance grows every single day, just from the interest. The more often interest is compounded, the more the fees…well, compound, growing a little bit bigger each time.
Using Compound Interest in Your Favor
I especially like the Albert Einstein quote in the infographic. Clearly, those who understand the true implications of compound interest are better off than those who don’t. The trick is to get compound interest to work in your favor. While you probably wouldn’t charge interest to family and friends that borrow from you, chances are that you have other ways of earning compound interest. Many investments and cash products provide you with the opportunity to earn compound interest. Regular contributions to accounts that provide you with the opportunity to earn interest can help you build up a nest egg, and prepare for the future.
While compound interest will work with one lump sum initially invested or deposited, you can build your wealth more effectively if you continue to add to your accounts. Regular savings and investments can help the power of compound interest work even more in your favor. (Of course, with investments you have to be careful, since you can lose money as well.)
In the end, though, compound interest itself is not necessarily evil. At least, not when you’re on the receiving end.