Improving Investor Behavior: The Sharp Knife of Compound Interest
Anyone who has ever spent time outdoors understands and appreciates the value of a sharp knife. Whether stripping wood to start a fire, using it as a cooking utensil, cleaning a fish, or for any of a million other purposes, the trusty knife is an essential tool. But knives also have inherent danger as well. Used the wrong way, a knife can quickly put an end to a fun camping trip, or worse – a life.
With this in mind, let’s consider compound interest. For those who don’t understand the concept, compound interest is money earned on money spent or saved, typically expressed as a percentage. If you have a savings account, you’ve earned interest (albeit a tiny amount). This interest is compounded (i.e., multiplied) when the amount is left alone over a period of time.
For example, if you have $100 that earns 5 percent per year, you’ll have $105 after the first year. If left alone, that $105 will be worth $110.25 the following year, not just the $110.00. Often referred to as the eighth wonder of the world, this compound interest is what drives investments and savings, and ultimately what allows people to retire.
Three essentials drive it: the amount saved (the principal ), the amount it earns, (interest rate expressed as a percentage), and time (how long is it allowed to work).
As investors, we seek to understand and control compound interest. Like the knife, when used correctly, compound interest is a powerful tool. Even better, the three variables behind compound interest can be put to work for anyone, regardless of income or amount saved. That’s why we’re big fans of starting early with savings. It puts time on your side. As you may recall from previous columns, it is the single most significant variable of the three.
Time in the market will always beat timing the market. For example, let’s say you had $10,000 to invest. If you could have invested in the Standard & Poor’s 500 (S&P 500) at these decades, today you would have:
- $32,100 if you had invested in 2010
- $29,181 if you had invested in 2000
- $155,468 if you had invested in 1990
- $783,050 if you had invested in 1980
- $1,384,183 if you had invested in 1970
- $2,936,957 if you had invested in 1960
This, of course, does not take into consideration fees, taxes, or other expenses. But it illustrates that investing in broad markets like those represented by S&P 500 over the long haul is an unmatched money compounding machine. The key is time. The longer you are invested, the higher the probability of a good outcome. Investing long term in a portfolio of great companies that sell their goods and services to everyone, every day, everywhere is what I describe as a “Compounding Financial Machine.” Long term ownership with this perspective helps protect the purchasing power of money – the goal of most investors.
But like the knife, compound interest can wound or even kill if misused. We’ve talked about how compound interest works with investments, but the same principles apply to debt.
Unless you are the United States Federal Reserve, money cannot be printed out of thin air. Whenever you spend more money than you have, you must borrow money to make that purchase. On the other side of the deal is someone loaning you the money you need. Borrowing the money comes with a cost, one that benefits the person loaning you the money.
Again, the three variables behind compound interest become essential. How much you borrow, what your loan interest rate is, and the amount of time you will take to pay back the loan, can all have a dramatic impact on the amount you will ultimately pay.
For example, let’s say you intend to purchase a $30,000 vehicle at 3 percent, with a plan to pay it off in six years. Your monthly payment would be about $456, which seems pretty average. But after six years, you will have paid about $2,818 in interest or almost an additional 10 percent of the original cost of the car.
Now $2,800 may not seem like a big deal, but apply the same math to other everyday expenses. A house purchased for $300,000 at 4 percent with a 30 mortgage has a monthly payment of about $1,432 (excluding additional costs like PMI, insurance, taxes, etc.) After 30 years of on-time payments, you will have paid an additional $215,608 in interest alone, meaning that $300,000 home actually cost you $515,000.
Credit cards are even worse thanks to their convenience and varying rates. According to creditcards.com, the average interest rate for a new credit card today is a whopping 26 percent. Assuming you have a balance of $10,000 and you’re paying the minimum every month (about $317), it will take you almost 30 years to pay off the debt, and you’ll pay nearly $31,000 in total on a $10,000 balance!
If you bump that payment up to $500 per month, you’ll pay off the amount in just over two years, paying a total of about $13,250.
That’s the power of compounding. An extra $183 per month saves you 27 years of payments and about $18,000. If that’s not enough reason to try and save a little extra each month, I don’t know what is.
The lesson here is simple: compound interest is an extremely powerful tool, one with which too many in the United States are hurting themselves. What may seem like small steps at the beginning, for example, like saving a couple of dollars here or making an extra payment there, can have a profound impact in the long term. Make compound interest work for you. Those who genuinely understand compound interest earn it, and never pay it.