Compound Interest – A Powerful Friend or a Terrifying Enemy (Your Choice)

By | October 22, 2013

Compound interest is a marvelous mathematical tool that’s either working for you or against you. Rich people stay rich and get richer by understanding the power of Compound Interest. Poor people stay poor and get poorer by an inability to use the power of compound interest.

It all starts with your income and expenses.

Rich

Keep your expenses line lower than your income line and invest the difference. Earn more than you spend. Take the excess and use your friend compound interest to watch your money multiply.

Poor

Keep your expenses line higher than your income line and borrow the difference. Spend more than you earn. Borrow from your enemy compound interest and pay more for everything.

Let me weave an absurdly simplified story about two brothers, Axl and Brick, and their co-worker, Compound Interest Charlie. Now, Axl and Brick, have identical incomes. They make a comfortable $40,000/year in a low cost-of-living city.  These two brothers are incredibly close, living together and splitting the rent and bills exactly even. In fact, they spend exactly the same amount on everything in their lives, almost to the point of ridiculousness. Up to the first $39,500 a year, Brick matches Axl penny for penny in every area of spending.

Brick takes that last $500 he earns in a year and gives it to Compound Interest Charlie. Charlie promises Brick that he will pay him 7% in interest, compounded annually.

Axl, however, takes that last $500 he earns and buys a can of soda for $2 per day, $10 per week, $500 per year. Unfortunately, Axl loves soda and needs at least two cans a day to satisfy his cravings. So, he borrows $500 a year from Charlie to fund his indulgence.  Charlie charges Axl 20% interest, compounded annually, like his dad Credit Card Colin taught him.

  • Axl and Brick’s income: $40,000/year
  • Axl’s Expenses: $40,500
  • Brick’s Expenses: $39,500

Here is Brick’s income and expenses chart over 10 years.

And Axl’s income and expenses chart.

I know. They look identical, right? We are only talking about a few hundred dollars here, less than 2 percent of their income. Let’s zoom in and put them both on the same chart.

Only a few hundred dollars a year. But the few hundred dollars a year was either spent befriending Compound Interest or defying him. Axl thinks that his future self will be able to pay for his soda habit easier, but it’s just the opposite. The longer he waits, the more money he owes. Brick is on the other side of the equation. The longer he waits, the more money he receives.  Let’s take a look at their net worth charts after 20 years.

Axl took $7800 over 20 years and got on the wrong side of Compound Interest. He now OWES more than $87,000!

Brick took $7800 over 20 years and got on the right side of Compound Interest. He now RECEIVES more than $17,000. 

The  amazing thing about compound interest is the compounding part.

Spend less than you earn and invest the difference and RECEIVE interest on the interest on the interest on the interest on the interest on the interest (you get the idea). It builds on itself. 

Or spend more than you earn and borrow the difference and PAY interest on the interest on the interest on the interest on the interest on the interest on the….

Rich people receive compound interest. Poor people pay compound interest. The rich get richer because of compound interest. The poor get poorer because of compound interest. Powerful friend or terrifying enemy.

Here’s the thing – your savings rate matters more than your income!

9 thoughts on “Compound Interest – A Powerful Friend or a Terrifying Enemy (Your Choice)

  1. Shannon

    You are the cat’s meow! Indeed! Been saying this for a LONG TME! GREAT POST!

    Reply
  2. Pingback: For Nonbelievers, a Financial Plan | Green Wizards

  3. Sheila

    Interesting how powerful compounding interest is. People also need to keep in mind that inflation is also in this race that you need to beat. If you do nothing, than you lose purchasing power over time which will eventually impact your quality of life. keep on investing and don’t worry about what is going on in the market.

    Reply
  4. Diana

    I read this all the time, but where can I start giving to Compound in order for cash to grow? That’s the question I always have had! I do appreciate for your input.
    Thanks so much!

    Reply
    1. Thriftygal Post author

      My investment vehicle of choice is VTSAX. I have a post entitled “Thriftygal’s Money Strategy” if you want to learn more.

      Reply
  5. Frankie911

    I researched VTSAX after reading your several comments about it and see it has a 10k minimum to start…. Are there any other Vanguard funds or elsewhere that you would suggest researching with a minimum investment closer to 3k? Would love your input. Thank you!

    Reply
    1. Thriftygal Post author

      VTSMX is the same as VTSAX, but with a lower minimum requirement ($3k) and a slightly higher expense ratio. The good news is that once you reach 10k, it automatically switches to VTSAX and the lower expense ratio. 🙂 I love Vanguard!

      Reply

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