Time is Money is Compound Interest
Let’s talk about compound interest. Compound interest can be your worst nightmare—when you’re the one paying it on your credit card debt, mortgage, and auto loans. But it can be your best friend when you’re the one RECEIVING it—that is, through investing.
Generational wealth is not built by working hard and keeping your head down. It’s built on the back of compound interest.
A brief introduction on interest if you’re not already familiar:
Interest is the small fee for the privilege of borrowing money. The interest you pay on your mortgage is the fee for the benefit of being able to live in a home while you’re still paying back your mortgage lender. The interest YOU earn on a stock or bond is that company (stocks) or the government (bonds) paying YOU a fee for the privilege of borrowing YOUR money.
Compound Interest is when the borrower has to pay interest on interest. If the interest collected each month is simply added to the total borrowed amount, then the next year—even with the same interest rate—the borrower must actually pay more for the privilege of borrowing that money. This is how credit card companies can absolutely destroy you financially if you carry a balance on your credit card into the next billing cycle. This is also why minimum payments are for suckers.
When compound interest is your worst nightmare.
Let’s say you charge $100 to your credit card, which you roll over to your next billing cycle and your credit card annual percentage rate (APR) is 18%.
Credit cards usually compound interest daily, which means every single day you carry a balance, you are charged a small fee for the privilege of leaving that balance unpaid. This means the next day, you’re not only charged a fee on the original carryover, but you’re also charged a fee on the fee from the first day you carried it over, and so on, and so on, until you pay the entire balance in full.
Credit card companies exist to make money.
They understand the power of compound interest (sorry) probably better than you do, and they purposefully position minimum payments so you’ll never be able to pay off your credit balance—especially if you continue to add to that carryover balance. Most credit cards set their minimum fee at about 1% of the total balance or about $30, whichever is more.
How long will it take to pay off $1,000 credit card debt with minimum payments?
Let’s say you carry a $1,000 credit card balance into the next billing cycle. Your minimum payments will only be $30. Seems incredibly manageable! But now let’s add the compound interest.
I encourage you to do the calculations yourself with Calculator.net’s Credit Card Payoff Calculator. Don’t worry, this is not an affiliate link. I just really, really love their calculators and have a few more recommendations in my Helpful Links page.
Set the “Monthly budget set aside” to equal your minimum payments, which in this case is $30. Input $1,000 into the “Balance,” $30 into “Minimum Payment,” and change the “Interest Rate” to 18%. In this scenario, you’re only paying off one credit card, so delete the other card balances. Click “Calculate.”
To pay off that $1,000, at $30 a month with an 18% interest rate, it will take you 3 years and 11 months. By the end, you will have paid an additional $397 on top of the $1,000 principal balance.
How long will it take to pay off $5,000 credit card debt with minimum payments?
Now run the numbers again with a $5,000 credit card balance and $50 (i.e. 1%) minimum payments.
The calculator won’t compute it, because there is no reasonable mathematical answer; you will never be able to pay off that balance with only $50 minimum payments.
Now set the minimum payments to $76 (this was the absolute lowest number I found where the calculator would compute a payoff timeline). It will take over 24 years to pay off $5,000 with $76 minimum payments. In the end, you will have paid over $17,000 on interest—over $12,000 more than the original loan amount.
Minimum payments are for suckers.
Unless you are in crisis, pay off the entire balance of your credit card each statement period.
If you are currently carry a balance on your credit cards, I recommend Calculator.net’s Credit Card Payoff Calculator to understand how long it will really take to pay it off. Feel free to play with your “Monthly budget set aside” amount to see how to pay off your credit card balance faster. How much you increase your monthly payments is up to you.
As I like to say, make a deliberate decision, not a decision by default.
When compound interest is your best friend.
Yes, it’s very upsetting running credit card payoff numbers. But what if you were instead on the receiving end of that compound interest? This is investing in a nutshell, and it’s how we (middle America) become rich.
I encourage you to open Calculator.net’s Investment Calculator to follow along. This calculator is my absolute favorite (because I get to find out how rich I’ll be)! Full disclosure, I regularly whip it out before bed to help me wind down for the evening–I like being reminded that my financial future is going to be just fine in the long term.
Compounding interest over 20 years
For the sake of this scenario, set the “Starting Amount” at $0, the “After x years” to 20, the “Return Rate” to 9%–the S&P 500’s average return rate over an extended period—and set the “Additional Contribution” to $100. You can leave the “Compound” and contribution timing as they are. Click “Calculate.”
This calculator projects, if you invest $100 each month in a stable S&P 500 index fund with an average, long-term 9% return rate, for 20 years, you will have a total investment portfolio of $63,000. This is great!
But I want to draw your attention to the “Breakdown” pie chart toward the bottom right hand corner. This will tell you what percentage of your final investment portfolio will be your contributions versus the compounding interest. In this scenario, 38% of your portfolio will be your contributions while 62% will be purely the interest you earned (i.e. profit). In other words, you have tripled your money over the course of 20 years.
Compounding interest over 30 and 40 years
Now do the same calculations, but change the time frame to 30 years. After investing $100 every month for 30 years into a stable index fund (averaging 9% returns), your investment portfolio will be worth $170,000—79% of which is compound interest!
Now do the same calculations for 40 years. The investment portfolio will be worth $421,000—89% of which will be compounding interest!
The point of this exercise is, of course, the power of time. As the saying goes: time is money. I want to extend this to: is compound interest. If you invest consistently for 20 years, your total portfolio will be over 60% compound interest. If you invest for 30 years, your portfolio will be almost 80% compound interest. And for 40 years, it’s 89%. This is why the earlier you start investing—regardless the amount—the greater your compound interest advantage.
Time is money is compound interest.
Make compounding interest your best friend. Start investing yesterday. Today is also acceptable.
Conclusion
If you’re not already investing, I implore you to start today!
As a current military member (active, Guard, & Reserve), you already have a Thrift Savings Plan (TSP) account—the government’s 401K plan. You can adjust your contributions through your myPay, “TSP Contributions” tab. If you joined after 2006 and before January 1, 2018, and you opted into the Blended Retirement System (BRS), you’re eligible for up to a 5% TSP match if you contribute 5%. Do this! It’s an immediate 100% return on your money! If you joined after January 1, 2018, you are automatically enrolled (Joint Knowledge Management Online).
If you’ve already separated, your company probably offers their own 401K plan. Talk with your HR and check your employee handbook. I recommend asking specifically about 401K matching options and the vesting period (how long until you can keep any matching contributions).
You can even open an Individual Retirement Account (IRA) or individual brokerage account online today with any major brokerage company (i.e. Vanguard, Charles Schwab, Fidelity, etc). IRAs have similar tax advantages to 401K accounts (I recommend opening a Roth IRA first).
Individual brokerage accounts are your general investment accounts. Since they offer no tax advantages, there are no restrictions for how much you can contribute or when you can withdraw, but any withdrawals are subject to state and federal income tax.
Since each account offers its own unique advantages, I personally have one of everything: (Roth) TSP, (Roth) 401K, (Roth) IRA, and an individual brokerage account. I also have a High-Yield Savings Account (HYSA)—but that’s for another post.
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