Compounding interest is so important to your financial well being, it is one of the four concepts used to determine a person’s level of financial literacy in the S&P Global FinLit Survey. Only 45% of people globally (55% in advanced economies) could answer the following questions on compound interest correctly:

Suppose you put money in the bank for two years and the bank agrees to add 15 percent per year to your account. Will the bank add more money to your account the second year than it did the first year, or will it add the same amount of money both years?

a) more
b) the same
c) don’t know
d) refused to answer

Suppose you had 100 US dollars in a savings account and the bank adds 10 percent per year to the account. How much money would you have in the account after five years if you did not remove any money from the account?

a) more than 150 dollars
b) exactly 150 dollars
c) less than 150 dollars
d)don’t know
e)refused to answer

Your Best Friend

Compound interest is fundamental to wealth building. Instead of interest simply being paid out to the investor, it is left in the investment to continue growing. Year after year, interest is paid on the cumulative balance of the original amount and all interest earned on that amount. It really adds up!

Warren received a $100,000 inheritance at age 30 and decided to invest it for his retirement. If he chooses an investment that earns 7% regular (simple) interest, his $100,000 will grow to $310,000 after 30 years. If he instead chooses one that pays 7% interest compounded monthly, his investment will grow to  $811,650 in 30 years.

Retirement savings plans and pension plans would not be able to accumulate the vast amount of investment dollars needed to pay out benefits if they didn’t take advantage of compounding interest and growth. Take a look at the long term charts in the Compound Interest and Retirement Reality Check modules to see the financial impact when money is left to grow.

 

“Consumers who fail to understand the concept of interest compounding spend more on transaction fees, run up bigger debts, and incur higher interest rates on loans. They also end up borrowing more and saving less money.”

 

– The Standard & Poor’s Ratings Services Global Financial Literacy Survey –

Your Worst Enemy

As great of a friend that compound interest can be to your wealth building, it is a much more powerful enemy when it works against you. Even though compound interest is used in mortgages and almost every other loan we may encounter, it is the impact it can have on high interest credit cards and pay day loans that can lead to financial disaster. Credit cards companies are masters of ‘just this side of legal’ deceptive jargon when giving the details of cards they offer. The low interest rate cards and/or special introductory rates come with so many conditions, most people end up paying a much higher rate than what they signed up for.  See: The Credit Card Trap

While the maximum interest rate a credit card in the U.S. can charge is 29% per year, it seems minor when compared to the staggering rates that predatory payday loan companies charge. Depending where you live, you could pay in excess of 500% interest a year on a payday loan. Even though some jurisdictions have consumer protections in place, including maximum allowable interest rates, you could still end up paying double (or more) of the amount you borrowed. Deceptive advertising may state an interest rate of 20 – 30%, but the true cost is lost somewhere in the fine print. The stated rate may only be for a very short period of time, such as a week or two, and if not paid when due, the full force of much higher daily compounding interest may be unleashed on you.

Compound Interest – “The Eighth Wonder of the World”