Compounding Interest- Friend Or Foe?

Compounding Interest

 

This is a term that is worth exploring. It is an accounting principle that will either make you feel very hopeful and excited about the future, or dred opening your bills. It is most likely the ONLY reason you will either retire early, or be doomed to a life of working forever, never really feeling like you are getting ahead.

 

Compounding Your Problems… Literally

 

“Compound interest (or compounding interest) is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan”

 

Essentially, when you purchase something with money you don’t have, it comes with a cost, and that cost adds dramatically to the price you pay for the thing you are buying. The faster you pay it off the less it costs, the longer you pay it off the more it costs, sometimes twice as much as what you thought you were paying for it. We live in a society of immediate gratification, and delaying what we buy because we don’t have the money is a very abnormal thing to the average person, yet another reason we are so damn poor!

Let’s look at the “average American” consumer debt to see what it looks like. We pulled these numbers from random internet sources, they all seemed pretty similar, but this appears to be close enough to the average.

 

Credit Cards $16,000 (15-22%)

 

Some sources put the average household credit card debt as high as $16,000… What!? We honestly didn’t think it would be this high. Credit cards are a death sentence to your savings. The average credit card interest rate is 15-22%. Again, it’s hard for us to understand because not only do we not hold any debt on credit cards that aren’t 0% interest, but the “daily use” credit cards we do have are either paid off every month so they don’t have any interest charges, and even then, are 10% interest or less cards. This only furthers our belief that most people do not understand the danger of these credit options. We couldn’t find any hard data on how long the average person takes to pay off this debt, and most the data implies that this is a constant carried debt, meaning they pay on the credit card, while simultaneously adding more… Keeping roughly the same balance and therefore roughly the same interest charges… Indefinitely!

 

Auto Loans $28,000 (4.46-8.56%)

 

Again, We really didn’t think the AVERAGE auto loan in the U.S. household would be this high… According to Experian the average auto loan in the U.S. carries an interest rate of 8.56% for used cars and 4.46% for new cars. Whoa! Through Rory’s business we have an auto loan at 1.39% and we don’t even like that! Just like other areas of our society, we have a wasteful mentality towards transportation. It seems to us, that people are CONSTANTLY “upgrading” their vehicles because their old vehicles are… well… “old”. We then purchase those and run them just fine… I guess they just LOOK old? The average pay off for car loans in the U.S. just passed 5 years. Just enough time for them to get another car that isn’t “old” we’re sure. Again, for most individuals the payment and attached interest charge probably stays about the same.

 

Student Loans $49,000 (6-8%)

 

Ahhh student loans… We are very happy to not carry any of these anymore. Kristen was fortunate enough to never have any because her family was able to pay for her in-state tuition, and Rory used his GI bill to pay for his two bachelor’s degrees, and half of his master’s degree. The remaining $45,000 was financed through SallieMae (Now Navient) at roughly 8% once he finished school. It was costing us $250/month just paying interest so we saved some money, sold some crap we didn’t need, and paid it off in one year… And we still lost $3,000 in interest before that could happen. We know people who have $150,000+ in student loan debt, surely a big fat anchor towards their independence. Our research indicates the average student loan debt is paid over 20 years!

 

Mortgage $179,000 (4.2%)

 

4.2% is the average mortgage rate currently (dropping in our current market). Obviously, the average person cannot pay for their home in cash, so this is mostly an unavoidable interest rate (at least better than renting for most people), and fortunately your interest rate on a mortgage is ususally a tax write-off, so its not as bad as other debt, and although we couldn’t find data on the average payoff time of a mortgage, the most common mortgage is 30 years, and our anecdotal experience is that most people take the full term of their loan to pay them off.

 

“Average” American Cost Of Interest

 

Lets assume this person is ONLY making their minimum payments on these.

$16,000 credit card at 15%, paying $360 as a minimum payment. If you only made the minimum payment on this, it would take you 382 months to pay off this card, and it would end up costing you $19,478.75 in INTEREST! In your first month your payment of $360 would only pay $160 towards the principal, the remaining $200 went to interest only.

$28,000 car loan at 8%, Making a payment of $568/month for 60 months. If you just made your minimum payment on this, it would be paid off in 60 months with a total cost of $34,064. It cost you $6,064 in interest over those 5 years. Put another way, it cost you $101/month in interest.

$49,000 student loan debt at 8%, Assuming you will take 20 years to pay off the debt, your minimum payment is $409.86/monthly and only $83 of that goes to principal your first month. You got it, $326 goes to INTEREST! The total cost doubles to $98,365 over those 20 years. You will have paid more in interest than you did for the principal.

$179,000 mortgage debt at 4.2%, on a 30-year mortgage, gives you a $875.34/month payment. If you only make the minimum payments, it will cost you $315,123. You will have paid $136,123 in interest. Of your monthly payment of $875 you will be paying roughly $600/month in interest to start with.

Wow… That was a lot of calculating numbers. Lets put it all together and see the cost of this long-term compounding interest that is the average American reality.

Total cost of having above debt (30 years to pay off house, 5 years to pay off car, 20 years to pay off student loans, and 32 years to pay off that credit card) $260,030.75!! And that is assuming this person NEVER buys anything else on credit during that 32 year period. When you look at these numbers it’s not hard to see why the average American complains about not having any money to save or invest, unfortunately they are trapped in perpetual debt and interest charges.

This person would be looking at their bills and paying $1,227 a month in interest alone. We don’t know about you, but we would be demoralized by that figure, feeling as though we were not able to get ahead, and truly not able to.

 

Compounding Your Success… Literally

 

Hopefully we have demonstrated the power of compounding interest over time, it appears that the average American generates about $250,000 of it over 30 years, the problem is that most of us are generating it for credit card companies and not for ourselves. Wouldn’t it be nice if we could get that snowball effect going into our own accounts? Well, we have good news for you, it is VERY possible!

The same principal applies to your investments (assuming you make them) as it does to your expenses. As we discussed previously, the stock market, if used properly, has an incredible ability to generate wealth over that same 30-year period. Let’s assume you are a NOT-SO-AVERAGE American, and carry little to no interest charges per month AND have some left-over income you can invest. Let’s see what happens when you do nothing other than ONE of the most common, easy, small investments each year. A Roth IRA. A Roth IRA allows you to invest up to $5,500/year in your early adult life, and withdraw it tax free at the age of 59 ½. Lets make a ONE TIME investment of $5,500 at age 18 and see what it looks like at age 60.

Assuming a market return of 7% on average over those years, your ONE-TIME investment of $5,500 becomes $94,293! Even though it was a very small investment, you made it early in life and allowed the power of compounding interest to work in your favor. Now that we have the wheels greased, let’s ask the obvious question. “If $5,500 does that in a ONE-TIME investment, what if I did that EVERY YEAR?”

So, let’s see what happens when we invest $5,500 a year, every year, from age 18 to 60.

Well. The bad news is that you had to put in $231,000 of your own money over those years. The good news is… You’re a MILLIONAIRE! At age 60, your IRA is worth $1,451,564! And all you had to do is come up with $5,500 a year to do so. We already demonstrated that the average American is throwing away $1,227 a month in interest ($14,724 a year) so it’s not like that money doesn’t already exist in our lives, we are just using our own money AGAINST us instead of FOR us.

 

Ugh… We are behind in this game

 

To us, it is very inspiring to get out our cell phones and crunch these numbers on compounding interest because we figured out how to make it work in our favor and we are going to use it to make us millionaires instead of keep us perpetually impoverished. In one of our previous blogs we talked about how we find ourselves saying “I wish we knew what we know now when we were 18, we would be retired by now”. The reason we say that is because we can’t imagine now how easily it would have been to come up with a few thousand dollars a year to invest no matter how poor we felt, now we feel like we are playing the compounding interest catch-up game, and need to aggressively invest in order to get caught up. Its not too late though. If you find yourself in a position like ours, just crunch the numbers, it doesn’t take long to get compounding interest working in your favor, and you have to start somewhere or it will never happen. Don’t delay, find the money in your budget to do it and you will start making money for doing nothing other than waiting.

4 thoughts on “Compounding Interest- Friend Or Foe?

  1. Our Frugal Escapades says:

    We don’t believe a 30-year mortgage is worth the money. We currently hold a 15-year which we are paying down aggressively. We have also maxed out our 401k(s) and contribute the difference to a taxable investment vehicle in order to take advantage of that compound interest. Compound interest really is a magical thing! 🙂

    Liked by 1 person

    • TheRoadToUnemployment says:

      We agree. A 30 year mortgage is fine in concept if someone has a strategy for paying it off much quicker than their terms, but the reality is in our culture that people get 30 year mortgages because it’s the only way they can get the payments low enough to be able to support their paycheck to paycheck lifestyle AND live in a house that is likely too big for them anyway.

      Liked by 1 person

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