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Futureproofing: Compound Interest Is Your Frenemy



First, an apology for using the term "frenemy." I hate this word but find it useful for this post.

What is compound interest? From our friends at Wikipedia: Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. How does it work? With stunning efficiency. For instance, if you have an interest-bearing savings account, compound interest is your friend, as your banking institution will pay interest (albeit a minisule amount these days) on the principal dollar amount. Over a long period of time, compound interest is earned on both the principal and accumulated interest, eg $100 principal + 5% interest = $105.00. Left untouched, your next round of 5% interest will be paid on the $105.00 balance, resulting in a sum total of $110.25. This is a simple (and unrealistic, in terms of interest paid) example of money making money.

If, however, you have debt on an interest-bearing loan, compound interest if your enemy. The kind of enemy that doesn't just want to conquer you, but humiliate before devouring your flesh and enslave your family kind of enemy. Suppose you have a credit card with a $1000 balance (see what I did there, with the debt being 10x the savings used in the previous example?) and an interest rate of 15%. After applying interest, your balance will be $1150.00; left unpaid, this will balloon to $1322.50 and so on. This doesn't begin to take into account late fees, etc. And your minimum payment? 2-3% of the balance, in many cases, but in ALL cases, much less lower than the interest rate. Lenders are betting you will run up a balance, then pay it off over time, which allows compound interest to do its dirty work. Avoid when possible.

I'll close with a quote from Albert Einstein: “Those who understand interest earn it, those who don’t, pay it.”

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