One day a mentor of mine posed the following riddle: “Sean, what did Einstein say was the most powerful force in the universe?”
“Gravity,” my ignorant, younger self responded.
“No…Einstein said, ‘compound interest; for he who understands it, earns it; he who doesn’t, pays it.’”
Since you are reading this, you probably have at least a nebulous understanding of interest. Perhaps, you’ve seen the word in credit card offers or mentioned in the sped up voices at the end of commercials: “0% APR and only 17.99% each year after that! Cash back, some restrictions apply; see offer for details.”
But what is it, really? And why would Einstein claim it to be the most powerful force in the universe when his ideas led to the creation of the atomic bomb?
Lets examine interest carefully and understand it together…
Imagine that you have $100 and you are ready to invest it. We will call this your principal amount. Then, you take that principal amount to the bank and put it in a special account that has a 10% interest rate (a highly unlikely scenario but please follow along).
Interest is the amount of money that is added to your principal amount ($100) that you invested. Since you invested a principal amount of $100 dollars in the bank with an interest rate of 10%, you would have that $100 dollars, plus 10% of that $100, or $110 at the end of one year. And at the end of the next year, you would have $110 plus 10% of that $110, or $121.
Without doing a thing except for letting time work its magic, in 15 years that $100 would transform into $417.72. That may not seem like a lot, but if we had used $100,000 as our principal amount in the above example, without adding a single penny, that $100,000 would become $417,724.82 after 15 years.
In reality, the rich continue to get richer using the magic of compound interest, while everyone else’s money continues to devalue due to inflation. Which side of compound interest do you want to be on?
For those of you who have debt and do not understand how compound interest works, you are being gradually robbed in ever-increasing amounts, each year (unless you have an active plan to pay off your debt).
If you owed $100 dollars at a 10% interest rate, you would owe the $100, plus 10% of $100, or $110 at the end of one year. After 15 years, you would owe $417.72. And worse, most credit card companies charge an interest rate of between 14% and 19% on any unpaid balance, so if you are not paying off your balance in full for each billing cycle, you are building up an ever increasing snowball of debt. Like Einstein said, “he who understands it, earns it; he who doesn’t, pays it.”
Before I had my rudimentary understanding of interest rates, I kept my money at Bank of America because they had ATMs everywhere. Little did I know, my money was consistently decreasing in value due to Bank of America’s subpar interest rates combined with the eroding nature of inflation on my money’s value.
Inflation describes the “general increase in prices and fall in the purchasing value of money.” Remember when movie tickets were $7 at Northgate? Or when a Coke costs 10¢ at the soda shop? With inflation, prices keep rising, but your dollar buys you less and less, every year. Indubitably, the cost of things will continue to rise and your purchasing power will continue to decrease, unless you grow your money.
And how do you grow your money…with interest!
Here are Bank of America’s interest rates on their saving accounts (at the time of this writing in Fall 2019:
Bank of America Savings Account
|Amount in account||Annual percentage yield or interest rate|
|Up to $10k||0.04%|
|$10k – $50k||0.05%|
|$50k – $100k||0.06%|
Yes, those annual percentage rates are all less than 1%. As a consumer, you have the power to choose where you keep your money. You can use the website, bankrate.com to compare the different interest rates for savings accounts. Make sure to check what the minimum deposit is, whether or not the bank is FDIC insured, what the number of withdrawals permitted each month is, and what minimum balance you need to maintain to not incur any fines.
To show why this matters, let’s compare how much interest you would gain on $1000, $50,000, and $100,000, at Bank of America versus a bank with a 2.1% interest rate which is fairly common:
|Amount||Interest accrued after 1 year at a .06% annual percentage yield (APR) or interest rate||Interest you will accrue 1 year at a 2.1% annual percentage yield (APR) or interest rate|
And for good measure, here is the same chart but after 10 years of growth with the same interests rates:
|Amount||Interest you will accrue after 10 years at a .06% annual percentage yield (APR)||Interest you will accrue 10 year at a 2.1% annual percentage yield (APR)|
But what if I told you that you don’t need to settle for a 2%, 3%, or even 5% interest rate or annual percentage yield on your hard earned money? What if there was a consistent, predictable way to earn an 8% interest rate or annual percentage yield on your money?
Google: what is the average return of the stock market since it opened?
Do you see what I am talking about?
But before you get ahead of yourself and go buy a bunch of random stocks, you need to learn about your investing options and how to move forward in a thoughtful manner, which will be my next article.
Did you make a change to your financial life after reading this article? Are you willing to share? Send me an email at: firstname.lastname@example.org and let me know your story.