Compounding Interest: Good vs Bad

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein

Seeing the Light

When I was teaching at the local Junior College, my curriculum had a chapter on MONEY, a chapter that I was excited to teach, as I got to talk about income, investing, retirement, debt, and compounding interest. In these teachings, I presented the concept of “Good Interest and Bad Interest,” both of which can be confounding.

Some synonyms of to confound are: dumbfound, baffle, perplex and confuse. From conversations with my students, most do not realize the power of compounding interest. Most, and I was one, didn’t really know what the interest rate on debt actually meant. I knew what the percentage rate meant, but I didn’t know what the “numbers” meant.  The numbers being the interest rate and how it interacts with the time to pay off.

I was confounded by compounding interest.

Bad Interest

Once I took the time to look at some numbers and educate myself about the real cost of interest in debt, I realized that compounding interest in debt is not a good thing.

The complexity of the compounding interest baffled me, as it did my students, but once I looked at the cost of paying off a loan to the end, I realized that it costs a LOT more when purchasing with debt, than with cash.  Debt interest is efinitely bad interest.

My students were amazed when I showed them examples of the numbers.  They also learned that debt interest is BAD.

Good Interest

On the other hand, I had learned, sometime earlier, the value of compounding interest in investing. Yep, that interest had confounded me for a while too, but I embraced that knowledge quicker.

Once I learned that compounding interest would allow my money to earn me money, I was enlightened.  l shared some calculations with my students, and they were amazed at how the compounding interest would grow money; just like I had been.

Investment interest is GOOD interest.  At the end of one class, one student came up and asked, “How do I get into something that will grow like that?”  I reached somebody.  🙂

Giving Away Money

Let’s look at some numbers.  I pulled these from a debt calculating site, http://ncalculators.com/credit-debt/debt-interest-calculator.htm:

A loan amount of $21,000, for a term of 9 years, at a rate of 17.89%, will result in the borrower paying $33,812 in INTEREST on top of the $21,000 owed.  The interest paid is MORE than the original amount of the loan? Yep, it is, so the borrower would have paid more than twice the actual amount borrowed if the loan was paid through its entire life.

Who has that kind of debt? I did when I purchased a time share a few years back. Stupid me, until I decided to pay the loan off early.  As Dave Ramsey would say, “I was paying the ‘Stupid Tax.'”   That $33,812+ was money that I was going to give away.

Money Making Money

Now, let’s look at some investment numbers, using an investment calculator site,

http://investor.gov/tools/calculators/compound-interest-calculator:

Earnings

In the loan above, my payments were $408 a month. If I had invested that amount, monthly, for 9 years, at 4%, compounded only once a year, I would have had, $51,814.79 at the end of 9 years, with an investment of $44,064.00, plus one dollar that I entered as the initial investment amount.

That would have netted me $7750.79 in earnings. Definitely not as much as what I would have paid on the loan above, but earning is better than paying.

Awesome, huh?  Interest doesn’t have to be confounding when you know the difference between GOOD Interest and BAD Interest!

So.  Are you earning money, or giving it away?

If you’re giving it away, what are you going to do about it? 

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About Keith

Keith, aka Shin, is a 50'ish former teacher and counselor who's blundered through the world of personal finance, learning the basics later in life than he likes. It's his mission to share as much about personal finance as possible, helping others get a handle on it, much earlier than he did.
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