“The most powerful force in the universe is compound interest”-Albert Einstein
We have all heard about compounding interest, but most of us don’t internalize how powerful it can be. What exactly is compounding interest? Simply put, it means that over time interest grows on itself, adding to the previous balance and increasing the amount that will be applied to interest calculations in future periods. In the next period, interest is calculated on this new, higher balance and is therefore greater than the period before. This causes the balance to grow at an accelerating rate over time. If Christopher Columbus had invested one penny at 5% interest when he hit the Americas, that investment would be worth nearly a billion dollars now.
Real Life Compounding:
How is this calculated in real-life and how does it impact your debt? Let’s say you start with $1000 in debt at 25%. If you don’t make any payments, how much would your balance be after a year?
Balance Year 1 = $1000 x (1+25%) = $1,250
In the following years, the new balance is calculated on the balance from the previous year:
Balance Year 2 = $1250 x (1+25%) = $1563
Balance Year 3 = $1563 x (1+25%) = $1953
Balance Year 4 = $1953 x (1+25%) = $2411
In mathematical terms, you can calculate the ending balance in year n by the following formula:
Ending balance (year n) = beginning balance * (1 + interest rate)^n (where n=number of years)
You can see that over time this compounding accelerates and increases balances quickly. How quickly? Just look at the following example. Over 10 years, $1000 compounded at 15% will grow to $4,046. At 25%, this grows to $9,313. Here’s a graphical representation:
Rule of 72:
This example illustrates a general rule of thumb often used in finance: to calculate how long it will take a balance to double with compounding interest, simply divide 72 by the interest rate. If you have a 25% interest rate, your balance will double in roughly 3 years. If the interest rate is 10%, the amount will double every 7 years.
What are the implications for debt? Since interest compounding is working unbelievably hard against you to increase your debt balances, paying off debt as quickly as you can keep it from compounding. If you make a payment against principal, all future interest payments are reduced by the amount of the interest savings. Over time, these savings add up and go straight to your pocket.
Scott Crawford is CEO of DebtGoal.com, a do-it-yourself system for getting out of debt and lowering your interest costs. DebtGoal.com incorporates all of the techniques discussed in this post and can help users understand and get visibility to and manage their debt finances.
Tags: compounding, compounding interest
