Today’s blog has the answer to one of the reasons you may not be getting ahead and stuck spinning your wheels. This one little word – compounding- can change it all.
You have been told to focus on interest rates and I am here to tell you it’s not about the interest rate itself, it’s also about the type of interest. This is another one of those things you are not taught to look at. Instead, you are brainwashed to focus on the monthly payment. Bigger issues are what is in that monthly payment and how is it figured.
I knew this was an issue that had to be addressed when I had someone make a comment about how amazingly fast their student loans are growing. Like so many others, I am not sure this individual knew their student loans compound monthly and some even daily!
There is a difference between compounding and amortizing interest and the difference is huge!
Compounding: This is when interest is added to the principal balance, again and again, each month, quarter, or year. This is an ever-increasing event.
Amortizing: This is when your interest amount is set based on the principal at the time a loan is taken. You then pay down this interest amount over the length of the loan.
To illustrate the difference between the two takes a look at the below graph. This graph represents the effects of compounding vs amortizing interest.
What you see is $30,000 compounding at 4% interest over five years has earned $6,630 in interest. While a $30,000 loan at 5% with amortizing interest, cost $3,968 of interest over the same five years.
How in the world can a 5% interest charge cost less than you make on 4% earnings? Because with compounding interest you are earning money on money on money. Amortizing interest is set and you pay it down. One grows while one decreases! It is just that simple.
The Common Mistake
You do not want to have a loan with compounding interest because it will continually increase the and is very hard to get ahead with. Credit cards, home equity lines of credit and student loans have compounding interest. Some student loans compound daily! You all know credit cards compound monthly. Most have no idea that home equity lines of credit have compounding interest monthly as well.
How to Get Ahead
What you want is to put your money in a place where you can earn compounding interest. This one little thing alone will make a huge difference in the amount of money you are holding later in life. Just think if you had ten dollars and turned that into $20, then $20 into $40, and $40 into $80, and $80 into $160, and $160 into $320. See how fast that grows, this the effect of compounding.
What is important is making sure you are paying to amortize and earning compounding. Lenders are getting rich by charging you compounding interest, flip that around and earn compounding interest instead of paying it.
You are not supposed to be thinking like this. If you know what is good for you then you won’t be reliant on the lenders. Look at credit card companies, student loan lenders and payday loan businesses; they are not there to be nice. They are there because it is very profitable to take advantage of those who do not know the difference.
In summary, do not just look at that interest rate alone. Make sure you are asking what type of interest you are paying or earning. If you are paying to compound, get those loans paid off as fast as you can. Then look at where you are putting your money and make sure you are earning compounding interest.
This alone is one of the main reasons I put my money into whole life insurance. I can earn this compounding interest at rates higher than what banks and CDs are paying. In addition, they are paying me this same compounding interest even when I borrow against my money. (see the results of this in a blog post coming soon.) It is truly a win for the security of my future and can be for yours too.
As always please leave comments below or contact me. I am always happy to hear from you.