Albert Einstein famously said that compound interest is the most powerful force in the universe. He said, “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” Who am I to argue with such a smart guy?
Einstein suggests that compound interest can work for you or against you. The choice is yours. If you use it to your advantage with your investments, it will make all the difference over the long term. Long term is 30, 40, or more years, not five years.
Let’s explore how it can work against you. Let’s assume you have a 30-year mortgage of $200,000, and you are paying 5% interest. The principal and interest payment would be $1,073.64. That means that you will be making 360 payments of that amount. On that first payment of $1,073.64 only $240.31 of it goes to pay down the principal while $833.33 goes towards the interest. Each month a few more pennies go to the principal, slowly bringing it down. If you add up all of the payments (360 x $1,073.64), you would have paid a total of $386,510.40 over the 30 years; $200,000 went to principal and $186,510.40 went to interest.
If you simply take $200,000 and divide it by 360 payments (assuming no interest), you would pay $555.55 per month. So right away we see how devastating interest can be when it’s working against us. As you may know, the affect you have on the principal at the beginning is minimal, but allow me to further illustrate. In the first ten years, you have paid $128,836.80 for the privilege of buying the house. Sadly, after such heroics on your part, the remaining balance of the mortgage is $162,288.34. You have dutifully been paying your payments like a good little borrower, yet you barely moved the needle. The balance has gone down by less than $38,000 after 10 years (120 payments) of your efforts. This is an example of how compounding interest can work against you.
Let’s talk about something happy, because that previous example is such a bummer and can suck the fun out of ever buying a house (until you think about paying rent perpetually and never having anything to show for it, which is worse). If we use compound interest for good, we can harness its incredible power to help propel us forward. Einstein didn’t just say that it was pretty cool or good in some way; he said it was the most powerful force. Where? In your home? City? World? No. The universe. That’s pretty powerful.
Let’s use the same payment scheme as our mortgage example. Let’s even use the same interest rate for growth. If you were to make payments of $1,073.64 per month for 30 years into some interest bearing account, earning a mere 5%, do you have any idea what that account would be worth? Of course not. (Neither did I, but I have a HP12C Financial Calculator from 1989.) Those payments would have grown to $902,066. Does that seem crazy to you, too? With compound interest working against you, those payments would retire a debt of $200,000. With it working for you, they would grow to over $900,000.
Let’s say that you are able to squeak out a higher rate of return, because of your diligence and insight. If you earned 8% and made the same payments for 30 years, you would have grown your account to $1,622,517. If you only averaged what stocks have averaged since the 1920s (that is, 10%), your account would have grown to $2,468,473.
In all of these cases, we are looking at the same 30 years and the same cumulative amount of payments of $386,510.40. If you are paying interest, you will pay off a $200,000 mortgage. If interest is working for you, you could have anywhere from $900,000 at 5% interest to almost $2.5 million at 10% growth. Einstein understood the difference and would love to know that you do, too.
Footnote: This is not an illustration on mortgages but on compounding interest. Still, I can’t resist. In the above mortgage example, if you paid an extra $500 per month, you would have paid it off in 15 not 30 years. You would have paid a total of $285,390.30 instead of $386,510.40; that’s a cool hundred grand for your efforts.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.