Let Compound Interest Work for You

Throughout the year, I’m reviewing the top 20 lessons learned from Stan in my book “Your Mortgage Matters” (see last chapter for the list). This week we are on lesson #4. If you don’t have a copy, email me and I’ll send you one.

Lesson #4: Why Compound Interest is so Vital

Stan used the old “double a penny a day” routine when talking to the group of kids in the classroom when he was talking about how compound interest is so valuable. It goes something like this: Which would you rather have, $1,000,000 given to you right now or get a penny right now, but get the benefit of it doubling every day for a month? On the surface, you’d try to quickly do the math and get 14-15 days into it realizing that you were still under $500, give up and just respond that you’d take the $1 million now. But that is where the beauty of compounding becomes relative – the bigger the number that doubles, the bigger the number is that will double again. Granted, it is an unrealistic argument to have an investment doubling every day, but the point gets made. After 30 days, you’d have close to $11 million if you had taken the penny doubling every day.

Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” It’s a lesson that I wish more of us understood at an early age – and certainly one we should be teaching our younger generation. Because the sooner we get it and start saving, the more beneficial it will be to us in the long run. I visited with a young man this past week who was buying his first house. He was really sharp and had his financial house in order. He wanted to do a 15 year fixed rate loan. When I asked him why he wanted the 15 year loan, he responded that he wanted his house paid off by the time he was 45 (he was 30). I told him that I completely respected his wishes and would certainly help him with the 15 year loan if that is what he wanted – I’m all for helping clients get out of debt. But I asked him if he would be willing to let me show him a quick financial analysis. He said I could so I asked him what rate he thought he would earn on the money he currently had invested. He said he expected no less than 7% long term. He was buying a $250,000 house and borrowing $200,000. His principal and interest payment on the 15 year loan was $1,393 per month at 3.125%. A 30 year payment would have been $912 at 3.625%, or a difference of $481 per month. I then showed him that his balance on the 30 year fixed deal would be at $127,000 at the end of 15 years versus 0 if he went with the 15 year deal and had the loan paid off at that point. So he was immediately seeing the benefit of the 15 year loan. But then I showed him that if he invested the $481 every month, earning 7% (that he told me he expected), he would amass over $152,000 by the end of the 15 years – enough to pay the loan off and have $35,000 extra.

My point was not to convince him that doing a 30 year loan was better than the 15. Because of the lower rate, I could always argue that the 15 year loan is a better option – particularly if the payment fits well within a budget. I simply wanted him to understand the power of the money compounding if he chose to continue to be a wise saver. I then showed him that if he went another 15 years on the same route with the 30 year loan (saving $481 per month), his investment would grow to $585,000. If he started saving $1,393 per month in year 16 (the equivalent of the 15 year payment he had been making) and saved that amount every month for the next 15 years, he’d have $441,500 (over $140,000 less than the strategy using the 30 year loan). Obviously it takes a lot of discipline to save the extra money every month and not spend it. But hopefully you see the advantage of making your money work for you and taking advantage of compound interest.