Albert Einstein is widely credited to have said, “Compound interest is the greatest invention of the 20th century.”
Compound interest is interest on interest. Suppose you deposited $100 in a bank account that paid 6% interest compounded yearly. After one year, you earn $6 in interest (6% of $100). Instead of taking the $6, you keep it in the account. You now have $106 in your bank account. After the 2nd year, you earn $6 in interest on the first $100, and you earn $.36 in interest on the $6 in interest you earned the 1st year. The $.36 is compound interest. In other words, you earned interest on interest.
If you are an investor, compound interest is a profit multiplier.
However, if you are a borrower, compound interest is a costly expense!
Let us use another example of a home mortgage. The bank is the investor and you are the borrower. The bank lends you $100,000 and charges you 6% interest on the unpaid balance. You agree to repay a portion of the unpaid balance each month for 360 months (30-year mortgage).
Interest is stated as a yearly rate, but can be calculated for any period… yearly, quarterly, monthly, and even daily. Mortgage interest is compounded monthly. In the mortgage example above, at the end of the 1st month, one month of interest is added to the unpaid balance. Thus, $100,000 times 6% interest for one month equals $500 ($100,000 x 6% = $6,000 / 12 = $500). Therefore, before you even make your first mortgage payment, you owe the bank, not $100,000, but $100,500.
Lenders use a mathematical formula to calculate monthly compound interest on the unpaid balance of a mortgage. The formula is applied to an amortization schedule. The amortization schedule shows you the loan amount you repay the bank each month. In the mortgage example above, the repayment is $599.55 each month for 360 months.
At the start of the 2nd month, the loan balance is $99,900.45 ($100,500 – $599.55). At the end of the month, one month of interest is calculated on the unpaid balance of $99,900.45 and added to the loan balance.
At the end of 30 years, you repaid the bank $215,838.19. You paid $115,838.19 in interest for the privilege to borrow $100,000. In essence, you did not buy your home for $100,000… you paid $215,838.19 for your home!
As you can see, it all depends which side you are on in the compound interest equation.
The bank, as the investor, receives a profit of $115,838.19 from a $100,000 investment.
You, as the borrower, pay an expense of $155,838.19 for a $100,000 loan.
Earning compound interest can create wealth quickly. The longer you hold an investment, the more interest (profit) you earn. Any investment that incorporates compounding is an investment to consider.
Paying compound interest takes more money out of your pocket. The longer you owe a debt, the more interest (expense) you pay. Your goal should be to pay off the debt as quickly as possible.