Compound Interest: What It Means To You
What financial planners call the “miracle of compound interest” contains both a potential blessing and a curse for young people investing in their future. Compound interest describes what happens to money owed or invested over long periods of time. Here’s the arithmetic in a nutshell.
Suppose you borrow $1,000 at an annual interest rate of 10%. (Most interest rates are below 10%, but I’m using that number to simplify the example.) If you pay nothing to reduce your debt, at the end of a year you will owe the lender $1,100. If you go a second year without paying anything back, you will owe $1,100 + $110 = $1,210 and so on. If you extend the arithmetic, you will find that (assuming no payments and the same interest rate) the original amount owed will double in a little more than seven years.
And this is exactly what happens to many people who borrow large amounts of money for student loans. They borrow tens of thousands of dollars to finance a college education, then end up in low-paying jobs that barely cover living expenses, leaving them with little or no extra money to pay back their student loans. Interest accumulates on their loans and they — or their parents — never are able to dig themselves out of a hole. A recent report analyzing Parent PLUS loans, the most expensive type of federal student loan that parents can take out to pay for their kids’ higher educations, found that the average PLUS loan borrower still has 55% of the initial balance remaining after 10 years of repayment — and 38% after 20 years. The report said that most parents spend more time paying off student debt for their kids than they do raising them.
That’s the bad news. Now let’s look at the flip side of compound interest.
Suppose instead of borrowing $1,000 at 10% annual interest, you invest that amount each year in a savings or retirement fund with the same percentage return and do not take any money out of the account. The same arithmetic applies. At the end of two years, that initial $1,000 will have grown to $1,210 and so on down the line, doubling every seven years. If you start putting away thousands of dollars a year every year starting when you’re in your 20s or 30s, you may well end up with retirement funds of well over a million dollars. You might even be able to retire from work well before the typical age of the mid-60s.
Young people generally don’t think much about retirement when it is decades away, but long-term savings are also available to withdraw to meet emergency expenses or luxuries you can only dream about when young and struggling to make ends meet.
Here’s the kicker, though. In order to experience the miracle of compound interest, you need to have enough income to cover reasonable living expenses and still have a significant amount left over to invest for the long term. That’s almost impossible to do when you have student loan debt to pay off on a modest income.
It’s much more doable when you finance or trade education at a fraction of the cost, or even enjoy it for free thanks to an apprenticeship or employer’s training program. Treat yourself and/or your parents to a better life by exploring the trades.