- Compound interest is both Friend And Foe
- What every young person needs to understand about compound interest.
- The reality of credit card use in Australian's financial life
- Why ignorance can be very expensive
- Compounding Interest lives amongst us already
- Working against you and working for you
- When it comes to investing
- When it comes to credit card debt
- Compound interest as a financial tool.
- What it means in real life
- Say Hello to the Rule of 72
- How it works
- Play to your strengths and make friends with the government's MoneySmart Credit Card calculator
- Questions I ask myself and my credit card (often)
- The importance of reminding yourself about your financial goals for the year.
- Three keys to running safely with credit cards
- What to do now
Compound interest is both Friend And Foe
Many people never understand how basic interest calculations work even though they use a credit card on a regular basis.
- Some of us feel we’re pulled into using credit cards by the demands of our circumstances, time and money.
- Others feel enticed by the sweet sweet candy of instant gratification.
Either way, compound interest is probably already active in your life as both Friend and Foe.
The trick is to be able to tell the difference.
What every young person needs to understand about compound interest.
In my earlier article, Confessions of a 13 year old loan shark, I talked about simple interest - how an amount of money loaned, multiplied by the interest charged, equals a cost.
Here I'm talking about how compounding interest accelerates the interest charged and that can be your friend, or your enemy.
- It can help make you rich or keep you poor.
The confusing part is you probably have both the compounding interest Friend and Foe in your life right now so it's in your best interest to know how it's either working for you or against you.
The reality of credit card use in Australian's financial life
[This is the part that always generates the hate emails from people telling me ‘they pay cash for everything in their life and never owned a credit card’, or those saying ‘it's too dangerous to talk to Australians about debt in such a public forum because they may misinterpret it as financial advice and end up on a spending spree they can't afford’ etc.]
So just to keep Larry the Lawyer happy - this is not financial advice - it's just good advice and probably something we all missed learning in school because we didn't see its significance to our future lives. Well now we’re all living our future lives, so here goes.
Why ignorance can be very expensive
Compounding interest and credit cards are a lot like a chainsaw - really really useful, as long as you’re holding the right end.
- Some people use a credit card and don't pay the full balance each month and are prepared to pay interest on the outstanding debt, for this service.
- Some people do pay out the balance each month and don't incur interest for this service. (a bit like gaming the system)
And a lot of people would say they understand they’re paying for the luxury of having the option to use credit on demand when they choose.
Compounding Interest lives amongst us already
Most Australians use compound interest every day in our busy lives and it can be a useful tool.
- Sometimes it's working against us
- Sometimes it's working for us.
Working against you and working for you
If you're making a minimum repayment on a credit card - compound interest is working against you.
If you've been using a super fund to earn interest on your money (hopefully your choice of investments - the asset classes - are earning you interest on your interest) - compound interest is working for you.
When it comes to investing
The sooner you start investing the better because you have more compounding periods in your favour and you continue to earn interest on interest on interest.
When it comes to credit card debt
The inverse is true, the longer you leave it you have more compounding periods working against you and you continue to get charged interest on interest on interest.
The best time to plant a tree was 20 years ago and the second best time is now. The earlier you can take advantage of compound interest, the more time you will have for your money to grow.
Compound interest as a financial tool.
For the mathematically inclined, the compound interest formula, including principal, sum looks like this:
A = P (1 + r/n) (nt)
If you'd rather not do the math yourself, all good just use the government's MoneySmart Credit Card calculator to learn about simple interest.
What it means in real life
- Compound interest in the hands of a saver will earn you interest on your interest as it compounds over time. That's good news
- Compound interest in the hands of a borrower will charge interest on your unpaid balance and its interest, every compounding period. That's not so good news
Using a credit card as part of a plan to achieve a specific result is very different to keeping a pet credit card debt that kind of just snuck up on you and now wants to make a permanent home in your financial life.
Either way, taking advantage of compound interest is probably the most powerful action you can take to build wealth.
So it makes sense to understand the power of compound interest as a saver and a borrower.
Say Hello to the Rule of 72
As a kid, my Uncle (a reformed bookie) would insist on making all my trips to the shops ‘educational experiences’. *arrhg* (that's probably why I don't like going to the shops now).
I’d have to either learn to spell words written on shop windows in reverse or calculate how many years it would take to double your money, by comparing interest rates advertised in the bank windows we’d walk past.
A walk past 3 banks and a credit union would be a nightmare for me.
We would look at the bank's displayed interest rates and divide 72 by the interest rate to find out how long it would take to double your money.
- 4.8% took 15 years to double your money
- 5.3% took 13.58 years to double your money
- 8.7% took 8.28 years to double your money
The Rule of 72 is a simple way to find out how long it can take to double your money based upon an interest rate. The "rule" is actually more a helpful a guide but it's remarkably accurate, as long as the interest rate is less than about twenty percent.
How it works
Divide 72 by the interest rate and that's how long it will take to double.
(You can use the government's MoneySmart Credit Card calculator to check the results).
Here's one I made earlier:
At 5%, how long will I need to double my savings?
- 72 divided by 5 equals 14.4
- This means it will take about 14.4 years to double my money (and if you want the precise answer it’s 14.21 but you can see the rule of 72 gets you darn close.)
At 7%, how long will I need to double my savings?
- 72 divided by 7 per cent 10.29
- This means it will take about 10.2 years to double my money (and again if you want the precise answer is 10.24.)
You now have a basic financial tool to help you work out how long it can take to double your money based upon an interest rate.
Play to your strengths and make friends with the government's MoneySmart Credit Card calculator
Whenever I need some motivation to resist putting another major purchase on my credit card, I take a look at the governments MoneySmart Credit Card calculator for some straightforward self-talk (and a reality check).
Questions I ask myself and my credit card (often)
- How many hours will I have to work to afford this purchase?
- What's the credit card going to charge me for this?
- After the first rude awakening, if I committed to doubling my minimum repayment, then tripling, etc what will it finally cost me?
Here's a screen capture from the credit card repayment calculator.
The importance of reminding yourself about your financial goals for the year.
After my three questions above, I usually find myself remembering what my bigger financial goals are and I wonder why I seem to forget them so easily when presented with a sale (or a discount because it was a floor stock or a company demonstrator, etc.)?
I usually decide to add it to a ‘saving for list’, and come back to it in a few months when my cash flow has caught up to my appetite for late-night eBay purchases and shiny new things.
Yes, I agree this sounds like being told to just wear sensible shoes (I see it more like not running with Scissors and Credit Cards), but this is one way I manage my money matters better and balance prioritising and delayed gratification to reduce the amount of time I have to work, to afford something.
Three keys to running safely with credit cards
- Knowing a credit card company compounds the interest on your unpaid balance monthly, should be motivation to try and pay off the card debt as quick as you can.
- Knowing you can make money from your money should be an incentive to find a high-interest savings account and look at how you can make money on your money
- Wherever you have a friend or a foe, (or a little bit of both) in your financial life at the moment, the trick is to start reducing your bad debts today and learning more about how to make more money on your money.
What to do now
If you have revolving credit card debt and are carrying an unpaid balance from one month to the next, make a plan to pay it off sooner rather than later.
Start with double repayments as a minimum and don't let compounding interest smother your life and keep you poor, by continually absorbing all your surplus cash.
Better some pain and frustration today getting debt sorted, then a financial life of disabling low-level dread of paying minimum repayments.
Have a look and see if compounding is working for you and then have a look at your credit card debts and see how it's working against you in the long-term.
It's time to get better with our money matters.