By now you know that if you invest $5,500 a year at 7%, you will have almost $1.2 million in 40 years. This is the wonder of compound interest working for you, but compound interest is a brutal double-edged sword.
If you own the money, compound interest is “your friend.” If you owe the money, well, we know, it is your worst enemy. Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t…pays it.”
The Wrong End of Compounding
A person who has taken on more liabilities than he or she can handle is easy to spot. Debt is that giant albatross around their neck—every day and every night—according to the American Psychological Association. (http://www.apa.org/news/press/releases/stress/2014/financial-stress.aspx)
How do people get caught in this death spiral of debt? Charge only $5,000 in one year, make 4% minimum payments ($200 a month), and it could take you over 10 years to pay the card off for a total of $7,180. But, who can only charge $5,000? Add another $5,000 in charges the next year and you are up to a $400 minimum payment every month and an extra year of debt. That $400 is almost a car payment, but you have no car. The original $10,000 in purchases ultimately can cost you an extra $4,360 in interest over the years. This is over $4,000 spent on nothing but air.
Obviously, the smartest use of credit is to only charge what you can afford to pay off at the end of each month. If full payment is not made, you are immediately subject to very high interest rates on any subsequent items you charge.
Be a Smarter Borrower
If you have to borrow, make extra payments toward your principal. Long term loans such as student loans, car loans, and home mortgage loans can be decreased and shortened appreciably by adding an extra $100 or $200 payment each month.
For instance, for a mortgage amount of $200,000 at 4%, for 30 years, you will pay $143,739 in interest over the life of the loan (if you hold on to the house and make all payments). Add $100 each month and the total interest amount goes down to $116,884 and the loan is shortened to 25 years. Add a total of $200 a month and the total interest is $98,810 and the loan is shortened to 21 years. Welcome to paying off your mortgage and the happiest day of your life.
Over Leveraged and Out-of-Luck
The saddest example of never-ending debt is the person who bought a house for $250,000, watched the house go up to $600,000 in value and borrowed against the new value. With the additional $350,000, they installed a new swimming pool, bought a couple of nice new cars on credit, and put money down on a second resort home. Then, they could not keep up with the additional loan payment. Housing prices crashed. Both of their homes went down in value—way down—and their cars were basically worthless. They faced foreclosure on both homes and both of their new cars are repossessed. Welcome to late 2008. These economies were based on rampant speculation, leverage, and greed. The banks got bailed out, but the borrowers did not.
Just Because…doesn’t Mean…
The smarter borrower knows that just because somebody is willing to lend them money doesn’t mean that they will be able to pay that money back. Many people mistakenly think that they would not be able to get a loan in the first place unless someway, somehow they can pay it back. Not true. Creditors play the averages and if the averages don’t work out, creditors have been known to receive government assistance.
Future Value means Future Prosperity
As was mentioned before, conquering your financial future requires understanding the “future value” of every $1, or every $20,000, you spend today. That extra $20,000 spent on a dream wedding could actually have grown to $345,000 in 37 years. That extra $30,000 spent on the ideal convertible translates into $517,000 in 37 years. If you borrowed the money for these items, the impact is even more profound. A wise person once said, “You can have it all now or you can have it all later, but very, very few people can have it all, all the time.”
(Illustration by David Darchicourt)