The Holidays And The Power Of Compound Interest
Fiscal Fitness – By John Gill
As you are reading this I am sure that in the back of your mind you may be contemplating some aspect of the holiday season. Whether Christmas, Hanukkah, or some other celebration, there are gifts to gather, decorations to deploy, or meals to make. One key ingredient needed in all these pursuits is money.
During the holiday season we find ourselves in the midst of merriment, hoopla, and joy. We also find the stresses of the season with our financial position under assault.
This month is a fitting time to talk about debt. Many will increase their debt levels through credit cards to make the holidays, “what they should be” and worry about the impact next year. Regarding debt, I am not going to talk about things to avoid. You already know that. I am going to give practical insight into the power of compound interest and how it affects debt.
Simply put, compound interest is when interest earns interest. Say you have $1,000 and you are paid 4% annual interest. At the end of twelve months the total in your account would be $1,040. At the end of twenty-four months the total would be $1,081.60, not $1,080 as many would have guessed. The extra $1.60 in our example is from the compounding effect. Compounding works for you on the investment side, but works against you on the debt or borrowing side.
Many wonder why it takes forever to pay down their credit card debt when they are making the minimum payments. Compounding is the answer.
Credit card debt is “revolving” debt. Because of the way interest is calculated on revolving debt, it’s difficult to tell how long it’s going to take to pay off the balance. The interest is compounded daily and each month that interest is added to the beginning principal so that the next month interest is calculated on that interest. The problem is compounded, no pun intended, when you add additional monthly charges to the balance.
With a fixed debt, your payments are scheduled for a fixed amount of time (like with a car loan). You can easily tell when you will pay off the principal on the debt and – even with the same interest rate and monthly payments – your pay-off date is usually much sooner than with revolving debt. Look at the table below to see the difference between revolving debt and fixed debt.
Revolving Debt Fixed Debt
(Credit Card) (Car Loan)
Amount Borrowed: $15,000 @ 15%* $15,000 @ 15%**
Total Monthly payments: $525 per month $525 per month
Years to payoff: 15 years 3 years
Interest paid: $8,156 $3,674
Total Cost $23,156 $18,674
Source – Equifax
*Assumes revolving payment (minimum) of 3.5% of the remaining balance or $20, whichever is greater. First month’s payment is shown and term assumed continued payment of minimum amount. No additional debt incurred and payments decrease over time period.
**Assumes payment of 3.5% of initial loan amount, no additional debt incurred and payment amount remains fixed throughout the term of the loan. This illustration is hypothetical only. Each debt situation will vary.
The compounding effect is very powerful and works for you with investments and against you with debt. If you must use debt, consider some fixed type of debt if possible.
To combat the need for debt, set a budget for the holidays, for food, gifts, anything that is required for the season. Discuss with the family and adhere to it. For next year’s holiday season, set aside a certain amount each pay period or month between now and then. When December 2017 arrives, you will have cash ready to go, and can start the 2018 New Year in a truly festive mood and maybe debt free.
If you have questions, comments, or an interest in an area of focus relating to finance that you would like to see covered in a future issue of The Park Press please call John at 407-353-0594 or send email to [email protected].
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