Expert Insight on Compound Interest: An Interview with MoneyGeek.com
by Investment Advisor Kyle Dodrill, CFP®, at Deschutes Investment Consulting
What are some of the uses of compound interest?
Compound interest is earning interest on your interest. The most widely known use of compound interest is in investing, specifically investing for retirement, but I can also apply it to credit card debt and revolving debt.
Here is an example of compounding interest. If you have $1,000 and it earns 5% over a certain period, at the end of that period, you will have made $50 and have $1050. Let’s say we reinvest your $1,050 at the same 5% interest rate. Instead of earning $50, you will earn $52.50. As you can see, if you continue to reinvest your earnings, the amount of money you make each period will increase even if your interest rate does not.
What do volatility and rate of return have to do with compound interest?
The two major factors that can influence how compounding interest affects your investment are volatility and rate of return. The higher rate of return you receive on your investment, compared to a lower rate of return, the faster your investment will grow. If your investment is subject to a rate of return that could vary from period to period, the amount of volatility in those rates of return will affect how much interest you obtain in each period and how quickly your investment will grow.
How can compound interest affect you in a negative way (i.e., credit cards)?
Individuals who carry significant balances on their credit cards or other revolving debt instruments can find compound interest working against them. Credit cards charge interest on the current balance of your account, not the original balance. So as your balance grows, you will pay more interest, even if the interest rate stays the same.
For example, if you have a $1,000 credit card balance with a 15% interest rate, the amount of interest that will be charged to you over a period is $150. Now say you make only a $50 payment on the credit card. Over the next period, your balance will be $1,100, and even if the interest rate stays at 15%, you will be charged $165.
How can it affect you in a positive way (i.e., savings and investments)?
Compounding interest can cause your wealth to grow faster than it would with simple interest. Even if not high-income earners, individuals can still build significant wealth if they start saving early in life and take advantage of compound interest.
If you plan your savings using compound interest, how should you consider the rate of return/assumption to include in your plans?
As you plan your savings, it will be very important to determine an appropriate return rate to apply to your investments. Overestimating how fast your investments grow can negatively affect your planning and cause individuals to have a lot less money than they were expecting. For conservative investors, a lower rate of return should be used to project how quickly their assets will grow. A higher rate of return can be used for more aggressive investors with a significant time horizon.