Compound Interest Overwiew

Some have remarked over the years that compound interest is the 8th wonder of the world. It can be, depending on what side of the equation you're on. When you are the borrower paying interest, you may or may not realize that the amount of interest you're paying nearly meets or exceeds the original principal you borrowed. This is most common with credit cards stretched out for months, but happens quite often with home loans. Here's a quick overview of compound interest:

Compound interest is named as such because the interest is calculated on the new balance each month (sometimes daily) to determine the payment schedule. This is important to know because interest is not calculated once, but monthly or even daily. Let me illustrate the difference:

If you borrow 200,000 at a 5% interest rate to buy a home and make payments for 30 years, under a simple interest plan you would only pay 10,000 in interest for the entire 30 years or about $28/month plus the principal paydown of 556, for a total of about $583/month. Now, those who have mortgages know it doesn't work that way, but do you know why? Compounding interest. Here's how it works:

Take the same 200,000 at 5% compounded monthly. Your principal paydown (the amount paid to reduce the 200,000 each month) is still about $556/month, but your total payment would be $1073.64 for principal and interest. If you divide the amount of interest paid ((1073.64-556) * 360) you get $186,120, almost the same amount of principal! Divide 186,120/200,000 and you get a percentage of 93.06%. That's your effective interest rate over 30 years, or a little over 3% per year. Compare that with simple interest where you pay 5% over 30 years, or about 1/6% per year, and you may never look at interest the same way.

The good news when you invest, compounding works for you. If you saved $1000 and had the choice of putting that into a certificate of deposit earning 4% or a mutual fund earning 8%, the difference is astonishing. Over a 20 year period you would have $2191 in the CD, but over $4660 in the mutual fund! If you could earn 10%, you would have 6727, nearly 50% more than at 8%. Put the power of compound interest to work for you my friends.

I will include a blog about how to use a spreadsheet program like Microsoft Excel to do your own projections of investments and borrowings. Also coming soon is a wonderful take on the "rent vs Buy" dilemma. You will be amazed at what you learn!