Understanding Compound Interest

Pop Quiz!

Compound interest, compound fracture, compound fraction – one of these can help you become filthy rich, and another can guarantee you’ll be a slave to debt and broke. Can you guess which is which? Surprise! The answer to both is compound interest. It doesn’t seem to make sense, does it? How can compound interest be your FastPass to riches and also your ticket to homelessness?

I love a good riddle, so let’s unpack this.

Compound + interest. What does this mean? Well, think of interest as what you get paid as an investor for owning an investment. For example, as an investor, you might get paid the following on these investments:

Bond – if you buy a bond, you get paid income every few months called interest

Real estate – rental income

Stock – dividends

Again, you are getting income because you own the investment. But what could you do with this income you get? Well, you could just leave it as cash. You know, just keep it in your account as good old cashola.

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What else could you do with it? You could spend it. That’s always an option. I mean, it’s your money, so you can buy whatever you want. And this is where things get interesting.

What could you buy with the money you’re getting paid as an investor?

New shoes. Upgrade your computer. Remodel the bathroom. Trip to Paris. Yes, yes, yes, and yes. But are we forgetting anything? Couldn’t you also buy more of the investment paying you the income?

This is where you get “compounding” from. You are taking the cash you are getting from your investment and buying more of the investment. This means next time you get paid, you get money from the original amount you put in, plus a little extra because your investment is larger.

So do you see how your investment can grow? It gets to the point where this farm you’ve cultivated takes on a life of its own and grows and grows.

Let me say this another way. Do you remember the story of Johnny Appleseed? I really hope not because I’m going to make up a lot of stuff about him, so work with me here, would you? Johnny Appleseed was a poor boy. He had no money, but he had a dream. He wanted to be the apple magnate of his time. He got his start washing cars. He barely made enough money to survive, but he was able to save a nickel after many months.

He cut open the apple, took the seeds, and planted them. Twenty years later, his little seeds turned into four apple trees. After the first harvest, he cut open the apples, removed the seeds, and planted those. He did this year after year, planting the seeds from his harvest to increase his farm. His farm grew from that first seed to thousands of apple trees because after each year’s harvest, he took some of the seeds and reinvested them to expand his apple empire. Each planted seed grew into a tree, which produced thousands of apples and even more seeds he could plant.

This is compound interest. It’s taking your income and using it to build and buy and expand your investment, so the next harvest produces even more. This is the power of compound interest.

So do you see how your investment can grow? It gets to the point where this farm you’ve cultivated takes on a life of its own and grows and grows.

The Downside of Compound Interest

Okay, so that’s the good compound interest, but it has an evil side few people realize. It works the same, but instead of growing your investment, it grows your debt.

Imagine you owe $10,000 in credit card debt. The nice credit card company understands that life can be tough sometimes, so instead of making you pay off the balance in one month, they let you pay just a fraction of the balance. Isn’t that swell? Oh, but you know, they’re not a charity, so they will charge you a bit of interest on the balance you haven’t paid off. And that interest they charge you, that goes right on the card. And the next month, they charge you interest on not just on the original $10,000 you racked up, but the $10,000 plus the extra interest they charged you. It’s compound interest, but this time, instead of increasing your investment, it’s increasing your debt! It grows and grows until you’re so far in debt that just the interest they are charging you is more than your paycheck. Think about that for a second. Because of compounding interest on debt you owe, every day you get up and go to work, you are actually getting poorer. That’s horrible.

The takeaway? Compounding is powerful.

It’s what creates exponential growth. Compound interest can work for you, creating wealth while you sleep or are on vacation, or it can work against you, digging you further and further into debt. The only difference between these two drastic outcomes? Are you the one lending or the one borrowing? So instead of buying debts, where you are the one paying interest each month, buy assets such as stocks, bonds, and real estate where you earn interest each month.

The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.