Concept of compound interest is powerful
The renowned physicist Albert Einstein supposedly called it the most powerful thing he had ever witnessed. But, unfortunately, many people do not understand and appreciate the concept of compound interest.
The power of compound interest can work for us and against us. It works for savers and investors and against borrowers.
Look at the impact on savers. With compound interest, savers receive interest on interest. As interest accrues on an account, it is added back to the account.
Over long periods of time, compound interest works its magic. If, for example, a parent invests $10,000 at the time of a child’s birth, that amount—at an annual interest rate of 5 percent—will exceed $238,000 when the child reaches 65. At 6 percent, it would be about $441,450.
Individuals making lump-sum investments can employ the “rule of 72” to determine how long it will take an investment to double in value. Dividing the rate of interest into 72 provides the number of years. At 6 percent, this would take 12 years.
Compounding works against borrowers. Look at the difference in the amount of interest paid on a $100,000 home mortgage financed at 6 percent for 15 years and for 30 years.
The 15-year mortgage costs $51,894 in interest over the life of the loan. But the thirty-year mortgage would cost an additional $64,000 in interest
–a total of $115,839.
The power of compounding can also be illustrated by credit card interest. Assume an individual has credit card debt of $5,000—the average nationwide is almost $10,000—at 18 percent interest and decides to destroy the card and pay off the amount owed. If he paid $100 per month, it would take 93 months to accomplish this. Increasing the payment to $200 would reduce the time to 31 months.
Compound interest is a fact of life. And it affects all of us in one way or another.
Wayne Curtis is on the board of directors of First United Security Bank. He can be reached by e-mail at firstname.lastname@example.org.