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Compounding Interest

Updated: Jun 7, 2023

Get ready to learn the most powerful, magical, revolutionary concept in finance. Which you probably also learned in third grade but didn't find nearly as exciting then.

As we all probably vaguely know, interest is "rent that you pay on money" (according to Khan Academy). If you borrow money for a house, car, or college, you'll have to pay interest on that amount. If you leave your money in a bank or bonds, the company (like Amazon or Bank of America) pays you interest for however long they get to use your money.

As you can see, interest can work for you (investing) or against you (loans and debt).

Say you invest $100 at a 10% interest rate. That's a rather high return, but quite possible in the stock market. Then next year, you'll have $110 in your bank account. With compound interest, you get interest on your original investment plus any interest you've already made. So the following year, you'll get 10% interest on the $110, which adds up to $121. Your investment not only grows every year, but it grows by a greater amount every year than the previous year.

This can be modeled by an exponential graph.

By comparison, simple interest is when you only earn interest on your principal investment. This means you would earn an additional $10 every year, based on an original $100 investment. This is linear growth.

So which do we prefer, compound or simple interest? As you can see, your investments will grow faster with compound interest. Luckily for us, most investments get compound interest. However, most debts do too.

The key to making money is understanding how to carefully navigate interest. How can you accrue the most interest? How can you pay the least interest? We want investments with high interest rates and debts with low interest rates. We want bonds that grow at 5% annually while only paying a 2.65% rate on our mortgage.

We work to eliminate high-interest debts (typically credit card debt) as quickly as possible and add to high-interest investments as much as possible. Of course, that's easier said than done.

Here's how I might prioritize spending my money:

1) Pay off credit card debt (15-25% interest rate).

2) Invest toward retirement in index funds (7-10% interest rate).

3) Pay off student loans (4-7% interest rate).

4) Pay off mortgage (2-4% interest rate).

5) Invest in bonds and less risky opportunities (2-4% interest rate).

6) Put money into a savings or checking account (0.01-1% interest rate).

To summarize...

Paying interest is stupid and annoying (almost like throwing away money).

Gaining interest is magic and awesome (almost like getting free money).

And understanding these basic concepts will help you get your bank account where you want it.

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