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How to Make Compound Interest Work For You!

How to Make Compound Interest Work For You!


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The Power of Compounding Interest

Albert Einstein reportedly said it. “Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t, pays it.

Do you know if you have compound interest working for you or against you?  This one opportunity is either the fastest way to wealth or the quickest fall into debt. We’re going to show you how to make compounding interest work for you, but first, let me explain what it is.

We deal with compound interest every day, and most of us aren’t even aware of the repercussions.  Are you currently sitting in credit card debt?  Do you have a mortgage?  Student loans?

You have a choice.  You either fall into the debt spiral, or you climb the ladder to wealth.

Why Compounding Debt Is Killing You

My goal is to teach you how best to make compound interest benefit you.  Before we get to that, though, let me show you how compound interest is destroying your financial goals.

In the U.S., according to Wallethub.com, in 2020, the U.S. had a total of $926 BILLION in consumer credit card debt.  This puts the average debt per household at $7,849.

Let’s take a look at how this works.  If you were to pay your minimum payment each month of $156.98 (2% of the outstanding balance) it would take you over 30 years to pay off your debt. You would have paid a total of $46,915.62. 

That is over $39,000 in interest!

Can you imagine how much interest you pay on your mortgage, car, and student loan payments?  In another post, I will touch on the effects of amortization tables and how we can grow our wealth through consolidation.  I do want to touch on one thing about mortgages, though. 

The 30 Year Mortgage Trap

Have you ever had someone smart telling you to get a 30-year mortgage?  And when that interest rate drops, after five years, you can go ahead and refinance that same mortgage to lower your payments even more?  Let us take a look at how a mortgage works.

While mortgages are calculated in simple interest, which is supposed to be great for consumers, the interest is front-loaded.  What that means is, you typically pay significant amounts of interest in the first 5 years versus the last 5 years.

In the following chart, I ran a quick breakdown of a 30-year mortgage in Portland, Maine, on the average house price.  I used that because I am located here, but you can easily adjust the numbers for your own location.  The numbers were mindboggling!

You don’t have to be a numbers guy to see that banks love it when you not only park your hard-earned cash in their checking and savings accounts, which may net you .10%.  They will loan that back out to you for a mortgage, all for the low rate of 3.25%.  Amazing, right?

Mortgage Payment Amortization Example

$350,000 Mortgage

DatePaymentPrincipalInterestBalance
Mar. 12, 2021$1,523.00$575.08$947.92$349,424.92
Total (12/31/2021)$15,230.00$5,821.41$9,408.59$344,178.59
Jan. 12, 2022$1,523.00 $590.85$932.15$343,587.83
Total (12/31/2022)$33,506.00 $13,018.17$20,487.83$336,981.83
Jan. 12, 2023$1,523.00 $610.34$912.66$336,371.49
Total (12/31/2023)$51,782.00 $20,452.34$31,329.66$329,547.66
Jan. 12, 2024$1,523.00 $630.48$892.52$328,917.18
Total (12/31/2024)$70,058.00$28,131.76$41,926.24$321,868.24
Jan 12, 2025$1,523.00 $651.27$871.73$321,216.97
Total (12/31/2025)$88,334.00$36,064.52$52,269.48$313,935.48
Jan 12, 2026$1,523.00 $672.76$850.24$313,262.72
Total (For 5 full years)$91,380.00 $37,411.86$53,968.14$312,588.14
Interest Rate of 3.25%

As you can see, in the first 5 years, you have paid $91,380 just in principal and interest payments (taxes not included).  Where did the bulk of those payments go?  $53,968.14 went straight to interest!

If you were to refinance your house, you’d get a smaller payment, but the numbers will work out the same.  Now, that heavy, front-loaded interest rate just starts over at zero.  Who is really winning here, you, or the smart marketing of the mortgage companies? 

What if there was a way to flip the script on the big banks?  Here I will discuss how you can put your money to work for you by explaining a simple story.  In future posts, I will discuss other avenues to invest assets to turn yourself into your own bank. 

This is no different than building a house.  We first must start by creating the foundation.  When you understand how investing works and why it can be a decisive factor in generating wealth, you can begin to make changes in your own habits.

The Story of the Doubling Penny

So, if you were given a choice of $1,000,000 today, or a single penny that doubled every day for the next 30 days, which would you choose?  Most people will go for the $1,000,000 but not you.  Oh no, you’re too smart for that.  You will take your delayed gratification today and see what happens with that single invested penny, aren’t you?

Let us look at the chart below and see how this ends up working out.

Power of Compounding Interest

When a Penny Doubles

Day 1$0.01Day 16$327.68
Day 2$0.02Day 17$655.36
Day 3$0.04Day 18$1,310.72
Day 4$0.08Day 19$2,621.44
Day 5$0.16Day 20$5,242.88
Day 6$0.32Day 21$10,485.76
Day 7$0.64Day 22$20,971.52
Day 8$1.28Day 23$41,943.04
Day 9$2.56Day 24$83,886.08
Day 10$5.12Day 25$167,772.16
Day 11$10.24Day 26$335,544.32
Day 12$20.48Day 27$671,088.64
Day 13$40.96Day 28$1,342,177.28
Day 14$81.92Day 29$2,684,354.56
Day 15$163.84Day 30$5,368,709.12
The math behind the concept

You see, it takes quite a while to get that penny going, but once it does get to moving, it goes quickly.  This is similar to the debt snowball we will talk about in another blog post. 

After one week, you only have a total of $0.64.  That is a scary thought, and your first thought is, boy, did I just make a huge mistake.

By week two, you’re a fair bit better off.  You have a whopping $81.92 saved up.  That is pretty grand, huh?  That could be dinner and a movie for you and your significant other if you’re frugal!

By the end of the third week, though, things are starting to look better.  Week three comes in at $10,485, or roughly 1% of what you would have had if you had a million dollars.  But – do you see what is happening here?  Do you know how this is quickly snowballing faster and faster?

It takes until the end of the 4th week to surpass that $1,000,000 mark.  And by day 30, can you believe it?  You have acquired over five times the amount you would have received if they had just given you the $1,000,000! You’re coming in at $5,368,709.12. 

How You Can Use Compounding To Change Your Life

I don’t know about you, but I know I could retire and live pretty comfortably on that chunk of change.  You will be comfortable too when you put all of the things we talk about here to use.  That kind of money builds generational wealth for you and your family.  If you do it the right way, you’ll never worry about the wealth disappearing after only three generations, as it happens to most families.

In the following graph, I will show you what would happen if you invested $6,000 a year.  This takes into consideration that you would actually be investing monthly at $500. 

By investing monthly, you are naturally building in a Dollar Cost Average routine.  (I explain Dollar Cost Averaging in this post). This is the best way to take advantage of market fluctuations to potentially get better pricing throughout the year on your investment. 

YearStarting BalanceInterestEnding Balance
1$6,000.00$696.95$12,696.94
2$12,696.94$1,232.70$19,929.64
3$19,929.64$1,811.31$27,740.96
4$27,740.96$2,436.24$36,177.18
5$36,177.18$3,111.12$45,288.29
26$495,586.33$39,863.85$541,450.18
27$541,451.18$43,532.97$590,983.14
28$590,983.14$47,495.59$644,478.73
29$644,478.73$51,775.23$702,253.97
30$702,253.97$56,397.25$764,651.23
8% return investing $6,000 per year

The $6,000 investment isn’t random.  This is how much you can invest inside of a qualified account.  In this scenario, I am showing you what would happen if you took those assets and invested in a Roth IRA.

Let me explain the importance of putting an investment like this in a Roth IRA.  As you can see in the chart, we have managed to put about $186,000 of our assets into this investment.  Over that 30 years, the investment itself, at 8% growth, has grown to $764,651! 

Now, if you are 59 ½ and you’ve held those assets for over 5 years (which we’ve been saving for 30!), you can access the full amount completely tax-free!  You don’t pay income tax.  That means no federal, no state, no FICA, or anything else that comes out of your paycheck.

The beauty of a Roth IRA is this. That $764,000 is tax-free. If you were to bring that home in an annual salary, you would make closer to $1.5 million!  Now, I am not telling you to run out and take all of those assets out at once. But this does serve to aid you in your retirement years without pushing your income levels up to unreasonable levels.

But back to the original point.  You just turned $186,000 into $764,000.  You had to go to work to earn money to set aside, but the earnings from the money?  That was laboring away while you were catching z’s.  It was working hard for you while you were spending time with your family.  It was getting stuff done while you were out doing the things that put a smile on your face.

I once read a book called Millionaire Fastlane by M.J. DeMarco, and I feel like he said it best.  Start thinking about the dollars you save as little freedom fighters out there fighting for you.  The more you put aside, the more they can start recruiting to build up your empire. 

I know that I’ve made many mistakes on my wealth-building journey. But it’s never too late to start making good choices. Every dollar you earn is a new opportunity to create those “freedom fighters”.

There Isn’t Only One Right Way

Using multiple wealth-building strategies to your advantage, you can quickly increase your compounding rate over time.  Suppose you genuinely want to reach a level of retirement comfort that you’ll never have to worry about money. In that case, you can start mixing in strategies of significantly decreasing your spending, maxing out Roth IRA contributions, your 401k, and even learning to use an HSA to your benefit (bet you never thought you could an HSA to build wealth!) 

Suppose you start giving yourself ten or more years to invest, putting all of these strategies in place. In that case, I have no doubt that your actual retirement numbers will be much higher than what I just showed you.

A lot of your returns will depend on the amount of risk you’re willing to take with your assets.  I have met many great people who have been driven to panic attacks by the mere thought of putting their assets into the market.  Others, I have seen them toss the bulk of their wealth at shady speculative investments without care. 

For most of you, you will likely fall somewhere in the middle of those two individuals.  There are several ways to actively invest in the market. My goal here is to discuss the different types of investment vehicles at your disposal and how you can invest in those.

So how do you get started?

That is a great question.  Before you start diving into throwing money at investments, you need to start with the foundation.  If you are entirely new to all of this and you haven’t really saved before, the first thing you should do is build up a savings account.

You should have a minimum of $1,000 in an immediately accessible savings account if something happens.  Suppose you’re single or you’re married with only one working spouse. In that case, you should have an emergency fund of 6 months expenses set aside before you start diving deeply into investing.  If you’re married and you both work, then you can cut the needed amount for an emergency fund down to 3 months of your total expenses. 

What that means is this.  Suppose you have expenses of $5,000 a month, and that covers your rent, utilities, loans, food, and all other payments as a single person or a household with a single income. In that case, you need to put $30,000 in savings. 

If you are married and have two incomes, you can cut that down to half, or $15,000 for your 3 months of expenses set aside. 

You can also start investing in your 401k, 403b, or any other type of investment you can get through work.  This is especially great if your company matches your contributions up to a certain threshold.  That is absolutely free money, and you should take it.

For those that already have all of this going, then you can open up individual retirement accounts.  This could be either a Traditional IRA or a Roth IRA if you don’t exceed income limits.  Congrats, you’re well on your way to reaching financial freedom! I’m going to be over here cheering you on.

Final Thoughts

In all reality, the main goal here is to just start investing.  Investing and flexing your financial muscle is a habit that is no different than going to the gym or taking time to eat healthily.  You have to take a disciplined approach to find success, and either the 401k or the Individual accounts will work to get started. 

We have walked through the Power of Compound Interest. We can see what happens when it is used against you. But look at what happens when it is working –for– you. We walked through the different avenues we can use to flip the script and get compound interest working on your side.

I leave you with this quote that has helped me get things going, especially when there was uncertainty.

To quote Martin Luther King Jr. “Take the first step in faith. You don’t have to see the whole staircase, just take the first step.”

Disclaimer: JustMyLittleMess does not provide tax, investment, or financial services and advice. The information is presented without considering the investment objectives, risk tolerance, or financial circumstances of any specific investor. It might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.