One of our readers emailed me with a finance question and I have been providing quite a bit of financial advice lately, so I figured it was time for another useful financial post.
Do you realise the impact of compound interest?
It is really powerful and understanding it properly should give you more insight into making some financial decisions.
Compound interest is the term describing the ability for an amount to grow as interest earned is calculated on the accumulating value. For example, $100 earns 10% a year. At the end of year one, the value has grown to $110. Year two $121, year three $132.10. So by the end of the third year, the original $100 is now not just 30% bigger, but 32.1%. Compound interest!
So why is this important to know?
If you have a mortgage at 7% interest, is it better to use the extra $100 on the mortgage or put into an investment?
Let's see, use a spreadsheet formula called FV (Future Value)
FV(rate, number of periods, payment, present value)
This $100 is worth $206.10 in ten years. That means you will be saving $106.10 in interest by putting that into the mortgage.
If you look at a credit card rate of 18%, it is worth $523.38 resulting in an interest saving of $423.38!!
If the money was put into any investment, the returns would not only be taxable, but to achieve the same returns would be very high risk. Paying out your debts is probably the best investment you can make.
If you have no debt, compound interest works in your favour. The earlier you begin putting money into savings or investments, the longer it has to grow. Note how the $100 doubled after 10 years with nothing extra being done? If you can avoid the downsides of compound interest in debt and gain the benefits of compound interest in savings and investments you have learned the secret.
The bottom line? Pay off debt before considering investing. Use the financial formulas in Excel or other spreadsheets and compare the different scenarios.
That's the lesson I learned from my Dad. Hate debt! As I asked Ariel when we were looking at a new nightie, "Is this worth a whole day's work?" She looked at me and said, "No. I think we'll make one or check out Vinnies."[Thrift store]
Do you realise the impact of compound interest?
It is really powerful and understanding it properly should give you more insight into making some financial decisions.
Compound interest is the term describing the ability for an amount to grow as interest earned is calculated on the accumulating value. For example, $100 earns 10% a year. At the end of year one, the value has grown to $110. Year two $121, year three $132.10. So by the end of the third year, the original $100 is now not just 30% bigger, but 32.1%. Compound interest!
So why is this important to know?
If you have a mortgage at 7% interest, is it better to use the extra $100 on the mortgage or put into an investment?
Let's see, use a spreadsheet formula called FV (Future Value)
FV(rate, number of periods, payment, present value)
This $100 is worth $206.10 in ten years. That means you will be saving $106.10 in interest by putting that into the mortgage.
If you look at a credit card rate of 18%, it is worth $523.38 resulting in an interest saving of $423.38!!
If the money was put into any investment, the returns would not only be taxable, but to achieve the same returns would be very high risk. Paying out your debts is probably the best investment you can make.
If you have no debt, compound interest works in your favour. The earlier you begin putting money into savings or investments, the longer it has to grow. Note how the $100 doubled after 10 years with nothing extra being done? If you can avoid the downsides of compound interest in debt and gain the benefits of compound interest in savings and investments you have learned the secret.
The bottom line? Pay off debt before considering investing. Use the financial formulas in Excel or other spreadsheets and compare the different scenarios.
That's the lesson I learned from my Dad. Hate debt! As I asked Ariel when we were looking at a new nightie, "Is this worth a whole day's work?" She looked at me and said, "No. I think we'll make one or check out Vinnies."[Thrift store]
1 comment:
Thanks for a great tip. My employer matches my retirement contributions up to 5% of my salary, so I try to contribute 5% of my salary each year. I think this comes out slightly ahead of where I would be if I just put the additional 5% into paying down my mortgage.
That still leaves the question of how to invest that retirement money. After much poking around I found a website that compares "socially responsible" or "ethical" investment funds. If you have an opinion, I'm curious.
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