5 myths about compound interest busted
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NUTS AND BOLTS 🔩: Compound interest is crucial to your financial future, but people regularly misunderstand it. Don't be one of them. These are the facts.
Compound interest isn't complicated. Here's the quick 101 version.
- You put $100 in a savings account which earns 10% interest each year.
- After the first year, you have $110.
- After the second year, you have $121.
- Not only did you earn interest on your original deposit, you've also earned interest on the interest from the first year.
Even more simply, you've scored $21 for doing literally nothing. The longer this goes on, the bigger the gains. In our example, after 10 years you'd have $271.
Stacking up those gains is why compound interest is so crucial to financial success. But simplicity doesn't mean people aren't confused about how it works, or how to best exploit it. Here are 5 popular compound interest myths, and the reality.
1. MYTH: Compound interest is always good news.
When you're saving money, compound interest is great. But when you're in debt, it's a curse.
Example: 3% interest over 20 years
Imagine you're paying off a $500,000 mortgage over 20 years with a fixed interest rate of 3%. Over that period, you'll pay $165,517.12 in interest. (More than 3%, isn't it?)
To pay this loan off in 20 years, you'll need to make monthly repayments of $2,772.99. In the first year, you'll pay back a total of $33,275.88. But you'll still owe the bank $498,477.
Compound interest means your debt barely moves in the early stages of the loan, even while you're making payments. (You can check the figures on Finder's home loan repayment calculator.)
So what's the lesson? For most of us, some debt is unavoidable. We'll take on a mortgage because experience shows our property value will generally rise, and because we don't have a spare half-a-million dollars lying around. Also, we need somewhere to live.
But if our debt doesn't ultimately result in a gain, compound interest is a killer. Paying interest on a credit card debt at 19.94% (the average rate in Australia) is a recipe for ongoing financial failure. Make compound interest work for you, not the bank.
2. MYTH: Compound interest is irrelevant when interest rates are low
Fact: Interest rates on savings accounts aren't very impressive in 2021. If you're getting more than 1% right now, you're doing well.
But that doesn't mean compound interest won't help.
Example: $100 in the bank
Let's take our original example of $100 in a bank account. After 10 years at 1% interest, that would be worth $110. That's certainly not spectacular, but it's still an extra $10 you wouldn't have otherwise. And if you deposit $10 every month over 10 years at 1%, you'll end up with $1,436.
The higher the rate and the more you can save, the better you'll do. But compound interest helps increase your savings even when rates are low.
3. MYTH: Albert Einstein called compound interest "humanity's greatest invention"
The Internet is littered with claims that Albert Einstein described compound interest as
"the greatest invention in human history" or "the most powerful force in the universe".
An endorsement from the most famous scientist of all time seems impressive, right? Unfortunately, it's not real.
A thorough investigation by veteran fact-checking site Snopes failed to find any form of this quote published in Einstein's own lifetime. The earliest version they located was from 1983, some 28 years after his death. The conclusion? The quote was "retroactively placed into the mouth of a prominent dead person to give it more punch", Snopes founder David Mikkelson wrote.
Bottom line? Compound interest is a great idea, and it doesn't need Einstein's backing to make it so.
4. MYTH: Compound interest earnings are swallowed up by other fees
Bank fees matter. Some accounts will charge a fee if you don't make regular deposits. Others pay less interest if you make any withdrawals during the month.
That doesn't mean that your interest earnings are doomed to disappear, however. It means you need to choose an account with a high interest rate and which doesn't charge fees.
Any time you open a savings account, make sure you understand:
- What conditions you need to meet to get the maximum rate. If you need to save a certain amount each month, have it transferred automatically.
- What fees are applied and how you can make sure you never pay them. Most high interest savings accounts in Australia don't charge fees. However, many of them require you to also have an associated transaction account, and those often do have fees. Take the time to check before you sign up.
And always compare accounts regularly to make sure you're getting the best deal. Rates and conditions change. Laziness will cost you. Don't leave it to chance. Put a reminder in your calendar to check six months from when you open the account.
5. MYTH: Inflation means compound interest is pointless
Inflation (the decreasing purchasing power of money) haunts us all. In Australia, the Reserve Bank has a target goal rate of 2-3% for inflation. If you can't earn at least that much from your savings accounts or investments, doesn't that mean you're actually going backwards?
It is technically true that if the interest rate paid is less than the current rate of inflation, money in a savings account may not be worth as much in real terms when you withdraw it. But there are other benefits to regular saving.
It helps your case when you borrow money
When you apply for a home loan, lenders will want evidence that you're capable of saving. Everyone needs an emergency fund. And the discipline of regular saving will set you up well for pursuing other investment strategies in the future.
On top of that, compound interest will help cushion the blow of inflation. Let's end by returning to that $100 earning 1% each year. A decade from now, $100 kept in a shoebox under your bed will still be worth less than $110 in a savings account.
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