Compound Interest: Unlocking Financial Growth or Catastrophe?
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Quote attributed to Albert Einstein.
Compound interest is like a magic snowball that grows bigger and faster as it rolls down the hill. When it’s working in your favour, it’s a beautiful thing, when it’s working against you it can be suffocating. In this article we’ll examine;
how compounding interest works
how compounding interest works against you if you don’t wise up to it (particularly in relation to bad debt) &
practical things we can do about it
In my next article we’ll talk about how the wealthiest people in the world all use compounding interest to their advantage, how you can too and what good debt vs bad debt is.
How compounding interest works:
Imagine you have some money in a savings account. The bank pays you interest. If this is simple interest it means you'll earn a fixed percentage on the initial amount of money you deposited, regardless of how much time passes.
Compound interest, on the other hand, pays you interest on the initial amount you deposited but also on the accumulated interest from previous periods. It's like building a tower of blocks where each new block rests on top of the previous ones.
As a simple example, let's say you deposit $1,000 into a savings account that offers an annual compound interest rate of 5%. After the first year, you would earn $50 in interest, bringing your total balance to $1,050. In the second year, instead of earning interest only on your initial $1,000, you'll earn interest on the new total of $1,050. This means you'll earn $52.50 in interest, making your total balance $1,102.50.
As time goes on, the interest keeps getting added to your initial deposit, and you earn interest on the new total every time. So, with compound interest, your money grows faster and faster as the interest compounds. Add to that the fact that many investments compound monthly so the interest, on the interest, on the interest grows even faster.
To put it into a real-life context, imagine you planted a seed that grew into a tree. Over time, the tree not only produces more seeds but also grows taller and stronger, allowing it to produce even more seeds in the following years. Compound interest works in a similar way, where your initial investment grows, generates more earnings, and those earnings, in turn, generate even more earnings over time.
When you don’t understand it, compound interest will work against you:
Now lets talk about that in reverse. How can compounding interest work against you? When you take on bad debt. If you haven’t paid attention to your debt, it is like being on a ship sailing in calm waters, but you’re unaware there's a small leak in the hull. At first, it's barely noticeable, so you continue sailing without worry. However, as time passes, the leak becomes bigger, and water starts seeping into the ship faster and faster.
At first, you might try to bail out the water with a bucket, hoping to keep the ship afloat.
To avoid sinking, the ship's captain can take action at this point. They can take the leak seriously, head to harbour and engage experts to repair the boat. As they head back to port they can make sure they are paying attention to the environment, checking weather forecasts and adjusting course to make sure that they avoid any storms.
But as the leak grows if it wasn’t addressed early on, it becomes hard to keep up. The water accumulates and starts weighing the ship down.
If a storm approaches, the additional strain from strong winds and turbulent waves, will be enough to weaken the hull to a point where the ship starts taking on water fast. The more it fills up, the less control the Captain has and the harder it becomes to steer and keep the ship stable until it begins to sink.
In this analogy, the leak represents growing debt, particularly high interest consumer debt, and the water filling up the ship represents the interest, fees, penalties and additional charges accumulating on that debt.
Initially, the debt may seem manageable, just like a small leak but this is the time that you need to address consumer debt and repay it off completely. Instead often people will take on more and more BNPL, hire purchase, personal loans, car loans, credit card debt, and continue to refinance the debt over and over without actually paying any back. They get themselves further and further into debt without thinking about it. In this instance there are no immediate visible effects to their lifestyle and so no immediate consequences. Each of those actions though is like drilling another hole in the bottom of the boat. During this stage there are choices that can be made to adjust your spending and pay down debt that will mean you can keep the boat afloat until you have it fixed. Often though, people are blissfully unaware of what is on the horizon and so continue spending up to the maximum they can.
The storm in this analogy represents things like inflation, a cost of living crisis, an unforeseen job loss or other ‘external’ things that happen to us outside our immediate control. These events can intensify the challenges caused by compounding debt, much like how the storm is the catalyst that eventually sinks the ship. Bad weather is a part of life so the time to fix your boat is as soon as it sprouts a leak.
Sailing in a boat with a leak and then blaming the weather when your boat sinks might provide temporary comfort, as it shifts some responsibility to something external that you have no control over. However, that doesn’t change the reality that the boat has sunk, and the chance to prevent it earlier was missed. It is often the same with debt. We are unaware that we are about to get into trouble so instead of permanently paying off consumer debt we normalise it, become comfortable with it and miss our opportunity to get rid of it before the storm comes
What practical things can we do about it?
Make sure you are focusing on what is within your control and planning as best you can for those things that are not. What is within your control?
Get some help and the earlier the better. Speak to a budget adviser or a financial adviser who is committed to helping you payoff your consumer debt. If you have difficulty paying a home loan there will be a customer care team within your Bank who have been set up specifically to help customers in financial stress. Speak to them early on and make sure you can agree on a realistic plan that you fully understand for how to repay your debt.
Invest in yourself. Make it your mission to learn about finances. Make it a habit to learn a little bit each week. Just as interest compounds, so does the investment you make in yourself. First learn the basics. Then learn about your environment.
Spend consciously. Use less. Waste less. Adjust your standard of living down early to pay down your debt. Another way to look at it is that debt is borrowing from future-you’s income and reducing future-you’s standard of living. To do something about it, today-you has to pay back what yesterday-you has already used up / incurred. Do you really want to keep loading future you up with more and more burden?
Stop using spending as an emotional escape. Retail therapy is not your friend. Pay day loans, BNPL, hire purchase - if you can’t afford to buy it now without credit, tomorrow-you is even less likely to be able to afford the repayments.
Put some structure around your accounts to help support good habits.
Increase your income and use that to pay back more of the debt.
Sell assets to pay your debt off.
Understand the difference between good debt and bad debt. Don’t take on any more debt unless it is good debt and you know what you’re doing.
Refinance to a cheaper interest rate so you can pay MORE of the debt off at a faster rate (not so that you have to pay less or you are just kicking the can down the road and using it to borrow more).
Prepare for bad times ahead. Expect the best but be prepared for the worst so that you always have a back stop if the worst case scenario does eventuate. Up-skill now so that if your company gets into trouble and needs to make layoffs you’re the last one they want to let go of and if you are made redundant you have the best prospects of getting another job quickly.
Make sure you have an emergency fund and grow it over time. Scrambling for money every time something unexpected happens will keep you poor and keep you making the same excuses about why life isn’t fair and you can’t get ahead. Having an emergency fund will give you peace of mind and the flexibility to adapt when you need to.
Speak to a risk adviser. Think about what you could not afford to happen and make sure you insure for that.
Once you’ve done all the above steps, start to invest into income producing assets.
By paying attention to the basics of your own finances and the financial environment, you can take proactive steps to manage your debt effectively and navigate through turbulent times before you are left without options.
If left unaddressed, a leak can reach a critical point where it threatens the stability of the ship, just as excessive debt can jeopardise your financial stability. It can lead to a point where bankruptcy or mortgagee sale becomes a possibility.
It happens slowly at first and then before you realise it, all at once.
Ernest Hemmingway put it best in his book, The Sun Also Rises. When a character in his novel is asked “How do you go bankrupt?” he replies, “Two ways. Gradually, then suddenly”.
The key take away here is that allowing debt to compound unchecked can lead to severe financial consequences. It's essential to address and manage difficulty with debt early on and to seek professional financial advice.
So we’ve talked about how compounding interest can work against you. But what about how to use compounding interest to your advantage? And what is good debt and bad debt? What’s the difference? A convincing argument can be made for the use of strategic debt and we’ll talk through how and why with a few examples to illustrate in my upcoming article.
Author: Jessica Ford