NUTS AND BOLTS 🔩: Compound interest is crucial to your financial future, but people often misunderstand it. Don’t be one of them. These are the facts.
Compound interest is not complicated. Here is the fast version 101.
- You put $100 into a savings account that earns 10% interest every year.
- After the first year, you have $110.
- After the second year, you have $121.
- Not only did you earn interest on your initial deposit, but you also earned interest on the interest from the first year.
Even more simply, you scored $21 for doing nothing. The longer it lasts, the greater the gains. In our example, after 10 years you would have $271.
Accumulating these gains is why compound interest is so crucial to financial success. But the simplicity doesn’t mean people aren’t confused about how it works or how best to exploit it. Here are 5 popular compound interest myths and the reality.
1. MYTH: Compound interest is always good news.
When you’re saving money, compound interest is great. But when you’re in debt, it’s a curse.
Example: 3% interest over 20 years
Imagine paying off a $500,000 mortgage over 20 years with a fixed interest rate of 3%. During this period, you will pay $165,517.12 in interest. (More than 3%, right?)
To pay off this loan in 20 years, you will need to make monthly repayments of $2,772.99. In the first year, you will repay a total of $33,275.88. But you still owe $498,477 to the bank.
Compound interest means your debt barely moves at the start of the loan, even while you’re making payments. (You can check the numbers on Finder’s home loan repayment calculator.)
So what’s the lesson? For most of us, some debt is unavoidable. We will take out a mortgage because experience shows that the value of our property will generally increase and because we don’t have half a million dollars to spare. Also, we need a place to live.
But if our debt doesn’t ultimately translate into a gain, compound interest is a killer. Paying interest on credit card debt at 19.94% (the average rate in Australia) is a recipe for continued financial failure. Make compound interest work for you, not the bank.
2. MYTH: Compound interest is irrelevant when interest rates are low
Do: Interest rates on savings accounts aren’t very impressive in 2021. If you’re getting more than 1% right now, you’re doing well.
But that doesn’t mean compound interest won’t help.
Example: $100 in the bank
Let’s take our original example of $100 in a bank account. After 10 years at 1% interest, it would be worth $110. It’s certainly not spectacular, but it’s still $10 more than you would otherwise get. And if you deposit $10 every month over 10 years at 1%, you’ll end up with $1,436.
The higher the rate and the more you can save, the better you will do. But compound interest helps boost your savings even when rates are low.
3. MYTH: Albert Einstein called compound interest “mankind’s greatest invention”
The internet is littered with claims that Albert Einstein described compound interest as
“the greatest invention in human history” or “the most powerful force in the universe”.
An endorsement from the most famous scientist of all time sounds impressive, right? Unfortunately, it’s not real.
An extensive investigation by veteran fact-checking site Snopes found no form of this quote published during Einstein’s lifetime. The first version they located was from 1983, some 28 years after his death. The conclusion? The quote was “retroactively placed in the mouth of a prominent deceased person to give it more punch,” wrote Snopes founder David Mikkelson.
At the end of the line ? Compound interest is a great idea, and it doesn’t need Einstein’s support for it to be so.
4. MYTH: Compound interest income is eaten up by other fees
Bank charges matter. Some accounts will charge fees if you don’t make regular deposits. Others pay less interest if you make withdrawals during the month.
This does not mean that your interest income is doomed to disappear. This means that you should choose an account with a high interest rate and which does not charge fees.
Whenever you open a savings account, make sure you understand:
- What conditions you must meet to get the maximum rate. If you need to save a certain amount each month, have it transferred automatically.
- What fees are applied and how you can make sure you never pay them. Most high interest savings accounts in Australia do not charge fees. However, many of them require you to have an associated transaction account as well, and these often have fees. Take the time to check before registering.
And always compare accounts regularly to make sure you’re getting the best deal. Rates and conditions change. Laziness will cost you. Don’t leave it to chance. Put a reminder in your calendar to check six months from account opening.
5. MYTH: Inflation means compound interest is useless
Inflation (the diminishing purchasing power of money) haunts us all. In Australia, the Reserve Bank has an inflation rate target of 2-3%. If you can’t earn at least that much with your savings accounts or investments, doesn’t that mean you’re backsliding?
It is technically true that if the interest rate paid is lower than the current rate of inflation, the money in a savings account may not be worth as much in real terms when you withdraw it. But there are other benefits to saving regularly.
It helps your case when you borrow money
When you apply for a home loan, lenders will want to prove that you are able to save money. Everyone needs an emergency fund. And the discipline of regular saving will prepare you well to pursue other investment strategies in the future.
On top of that, compound interest will help cushion the blow of inflation. Let’s finish by going back to that $100 that earns 1% every year. Ten years from now, $100 kept in a shoebox under your bed is still worth less than $110 in a savings account.