Compound interest works together with time. It does not matter if you are investing or borrowing money; when time is added to the equation, compound interest comes into play.
When saving money, time can be your ally, and if you owe money, it can be your enemy. Time increases the amount of interest charged. Don’t be afraid! In both cases, you can use it in your favor.
As an illustration of compound interest when borrowing money, we will talk about car financing.
Carla wants to buy a new car, which costs $20,000. However, she doesn’t have enough money to pay for it in cash. She gave a down payment of $5,000 and will finance $15,000.
She wants to repay in monthly installments of a maximum of $650.00. The dealer offered two financing options: 24 payments of $646.00 or 48 payments of $333.00.
At first, Carla was attracted by the second option that has the smaller monthly payments and could allow her to invest some money in something else. In the end, she chose the first option of paying a higher monthly amount.
Why do you think Carla changed her mind?
She considered the total cost of the car the end of the finance period. Look the table below:
|Financing Options||Monthly Payment||Total Costs|
The total amount she will pay in the first option is almost $480 less than if she chose the second one!
When you finance a car, get a mortgage or take out a loan, the money you borrowed is charged with interest, which increases the amount you are required to repay. When you choose to pay the debt faster, less interest is charged.
Now, let’s think about the opposite situation of investing money.
This is a similar situation where time and compound interest work together. But the interest will work in your favor.
When investing money in a financial institution or a bank, you receive interest according to the type of investment, amount of money you invest, and the length of time you leave the cash with the institution.
What happens if Carla, rather than of financing a car, invests $650 monthly for two years?
At the end of the two year period, her bank statement would show an account balance of
It is possible because she would earn compound interest every single month that she keeps her money invested! At the end of every month, she receives interest from the bank at a rate of 2.1%. This interest increases the amount in her account. The next month and every successive month, Carla receives 2.1% interest based on the principal plus the interest earned the previous month.
The following table shows the balance at the end of the first and second years:
|Year||Year Deposit||Year Interest||Total Deposits||Total Interest||Balance|
When investing money, the interest is calculated based on your account balance. Investing more money every month increases your account balance and also increases the interest earned. This makes your money grow.
If Carla changes her mind and just keeps the money in this investment account without adding any monthly payments for five more years, at the end of the period, she will have earned even more interest.
|Year||Year Deposits||Year Interest||Total Deposits||Total Interest||Balance|
The initial deposit is the balance she had when she stops adding more money to the account, which is $15,945.87. After earning interest for five years, the final amount will be $17,709.62, without Carla doing nothing!
Make compound interest work for you! Reduce the time to repay your debts and increase the deposits and increase the time you keep your money invested. These are useful strategies to save money and also see your investments grow. This is a no-brainer.
Finjoy Capital is not a financial advisory firm.
This article is for informational purposes only and is not a substitute for individualized professional advice.