Compound interest adds up fast. Pay off your credit cards and high-interest loans first. (Photo Credit: CC BY/Dan Foy/Flickr)

When it comes to personal finance, few concepts are as important to understand as compound interest. Many consumer finance products use this form of interest. Knowing about compound interest can save you from a potential bankruptcy.

Compounding snowballs

The process of adding interest to principal is called compounding. Depending upon the type of personal loans, student loans, mortgages or other loans in question, interest is compounded on a regular schedule, be it daily, monthly, etc. Keep in mind that once compounding begins, interest itself earns more interest. This is a credit card company’s bread and butter, an easy way for a consumer to fall rapidly into debt. To understand the true cost of any credit card or loan, interest-related factors like how often the remaining balance is compounded and the annual percentage rate must be considered.

Compound interest should not be confused with simple interest. Simple interest is charged on principal balance only and doesn’t charge interest on accrued interest as compound interest does. Simple interest is quite rare in the field of consumer finance.

Doing the compound interest math

Here’s the math you need to know, using hypothetical numbers:

1. Divide interest charged by the amount you owe to produce the periodic interest rate. If you are dealing with personal loans in the amount of $3,500 and you’re paying $25 monthly in interest, divide $25 by $3,500 to get 0.0071428571428571.
2. Take the answer from the previous step and add 1. Now you have 1.0071428571428571.
3. Raise the result of Step 2 to the exponential power of the number of payments you make on the loan or credit card each year. If you pay monthly, you make 12 payments per year. Using the same figures, the result is 1.089163111.
4. Subtract one from the result in Step 3, which converts the compound annual interest rate to a decimal. Here, you have 0.089163111.
5. Multiply the personal loan compound annual interest rate you changed into a decimal number by 100 to create an easy-to-read percentage. Here, you’d take 0.089163111 and multiply by 100 to produce an annual compound interest rate of 8.92 percent.

Understand interest and avoid bankruptcy

Sources

Compound interest Wiki

eHow.com

Find a good financial planner to help you generate investing ideas. (Photo Credit: CC BY-ND/Brook Rushing/Creative Loafing)

People invest because they want to create wealth. Day traders may savor the adrenaline rush, but profit is the purpose. In order to invest effectively, however, it pays to know some basics. It also pays to know how not to invest.

Invest in a 401(k)

Experts advise getting started with a 401(k) plan from your place of employment, preferably with matching funds from the company. The money deposited is not taxable as long as it remains in the account, earning dividends, interest and capital gains. Let it sit for a while and gain interest for your retirement.

About.com reminds investors that a 401(k) is not an investment per se but an account that holds investments in stocks, bonds, mutual funds and more, depending upon your 401(k) variant.

Save for a rainy day

In addition to a retirement account, it is essential to establish savings. Online resources like Motley Fool or any worthwhile financial adviser can help you decide how much you should realistically be saving.

Max out your Roth or Traditional IRA

A Roth IRA retirement account gives you the flexibility to make contributions after taxes, so taxes are paid only upon withdrawal. Maxing out your contribution limits will enable you to build a fine nest egg. Even if you don’t qualify for a Roth, a Traditional IRA still grants you sizable tax benefits.

Expanding beyond the retirement account

Producing additional wealth can mean opening a brokerage account and buying stocks. Before investing, however, you should have a clear vision of your goal. Know what you want and how long it will take you to get there based upon the amount of the investment and rate of return.

Pay off your credit cards first

The interest rate on credit cards make them the worst debt consumers can hold. Take care of all credit card debt before beginning to invest in stocks.

How NOT to invest: Don’t sit on your hands

Motley Fool points out that stock market is unpredictable, but t if you venture nothing, you will gain nothing. The miracle of compound interest smiles upon those who buy in. If you invest in stocks and stop paying attention, you’re asking the market to swallow your cash. Follow your stocks and move on if and when the time is right. Remember your financial goals and don’t go too far outside your comfort zone unless you’re prepared for possible loss.

In and out is expensive

If you’re investing through a brokerage firm, frequent trading in and out of the market will produce major fees. Day traders make up for this in volume, but for the basic investor, long-term investments (ideally five years or longer) are the safer course. If short-term investment is necessary, consider money market funds or CDs, advises Motley Fool.

Sources

About.com

Motley Fool

From socks to stocks

Saving $1 million is considered necessary for a comfortable retirement, and most people could do it if they start early enough. Image: CC mmarchin/Flickr

Would you retire if you had a million dollars? Many financial advisers say that just about anyone can become a millionaire with the right money-saving strategy. However, by the time you retire, a lot of unforeseen circumstances will happen that affect the amount of money you save and the amount you need.

How to save $1 million

A million-dollar retirement is very feasible on paper, thanks to the miracle of compound interest. As you start investing you earn interest on those investments. You reinvest the interest and your money grows exponentially over time. In that case, the earlier you start the better. At age 20, an investment of $150 a month, assuming an optimistic 9 percent annualized return, will compound to about $1 million at age 65. Best of all, over 45 years you only throw in $85,000. Wait until 30 and you need to invest $350 a month–$147,000 total. Age 40: $900 a month, or $270,000.

How to retire on $1 million

If someone has a million dollars for retirement today, how much would they have to live on? Let’s assume a 4 percent interest rate compounded monthly, which is achievable with that amount of money in savings. Given those conditions, the millionaire could collect $3,333.33 in interest every month without touching the $1 million principal. Over time you can expect the cost of living to rise and interest rates to fluctuate wildly. At the present time, interest rates are so low that they are putting the hurt on people living on fixed incomes such as interest on savings.

A financially independent retirement

A million dollars is generally considered the benchmark for a financially independent retirement. How much a person will really need depends on a lot of variables. Whether one’s luck is good or bad as they go through life will have a major effect. How the economy behaves is another important factor (see Great Recession). A person’s lifestyle, health and how that influences life span is another. If you’re like many Americans without the lifetime of financial discipline described here, Social Security will help. And you’ll probably have to get a part-time job. But most people spend less as they get older. And money can’t buy happiness anyway, right?

Sources

The Globe and Mail

Accumulatingmoney.com

MoneyCentral

Credit repair is possible, but only if you increase your debt literacy. (Photo: flickr.com)

Do you consider yourself to be financially literate? How about when it comes to debt – is your level of debt literacy high enough that concepts like credit repair are second nature to you? Chances are your opinion of your debt literacy is higher than the reality. This is much in keeping with a trend numerous studies have observed in Americans: their level of debt literacy is less than adequate to deal with a complex financial market where important decisions – even on the average consumer’s level – can make the difference between a lifetime of saving or an endless cycle of debt. One recent study for the National Bureau of Economic Research by Dartmouth Economics Professor Annamaria Lusardi and Harvard Financial Management Professor Peter Tufano entitled “Debt Literacy, Financial Experiences and Overindebtedness” shows us just how far Americans have to go before debt literacy and credit repair become a part of the everyday financial lexicon.

Survey Methodology

Saving, investing and being prepared for retirement are vital elements of financial health and well-being. However, runaway personal debt and a widespread lack of basic debt literacy understanding tend to take the place of the more positive aspects for many Americans. What the authors attempt to do with their study is to examine the connection between financial literacy and debt. As the authors see it, debt literacy amounts to “the ability to make simple decisions regarding debt contracts, in particular how one applies basic knowledge about interest compounding, measured in the context of everyday financial choices.” To measure debt literacy, the authors worked with a market research company to create and conduct a survey that asks a broad consumer sampling three questions designed to assess their understanding of basic debt literacy concepts like compound interest. The questions were intended to be solved via reasoning alone, so they were simple enough that calculators were not needed. Afterward, participants were asked to rate their own knowledge of debt literacy.

What Did They Expect to Find?

If numerous studies on the financial knowledge of the U.S. consumer were any indication, it wasn’t going to be a fairy tale ending. Douglas Bernheim documented Americans’ lack of financial knowledge as early as 1995. They fail to understand basic financial concepts, “particularly those relating to bonds, stocks, and mutual funds,” and are quite fuzzy on such things as terms and conditions on large-scale loans and mortgages. This trend looks to continue on into the future, as a National Council on Economic Education study of high school students shows “a widespread lack of knowledge.”

Is this a uniquely American phenomenon? Sign point toward “No,” as a survey of Health, Aging and Retirement in Europe (SHARE) indicates poor scores on financial numeracy and literacy scales. Even a member of the U.K. Treasury reported that United Kingdom borrowers have “a poor understanding of mortgages and interest rates.” As a whole, studies in America and Europe show that those with a lower level of debt literacy were less than likely to have a well-developed retirement savings plan, accumulated wealth, stock investments or low-fee mutual funds. They were more likely to have more expensive mortgages, however.

Survey Questions and Analysis

Here are the three debt literacy questions utilized in the authors’ study. The first involves compound interest:

Suppose you owe $1,000 on your credit card and the interest rate you are charged is 20 percent per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?

A)     2 years;

B)      less than 5 years;

C)      5 to 10 years;

D)     more than 10 years;

E)      Do not know;

F)      Refuse to answer.

Ignoring interest compounding would lead to doubling in 5 years; someone who knew about interest on interest might have selected a number less than 5; someone who knows the ―Rule of 72 would know that it would be about 3.6 years (i.e., correct answer (ii) ―less than 5 years.). Answers above five years reflect misunderstanding of the concept of interest accrual.

Fewer than 36 percent of respondents got this one right. Considering how many people carry revolving balances on credit cards, that’s a troubling statistic, but less than surprising. Many consumers have difficulty grasping percentages and fractions, and compound interest deals with these. The authors found a particular problem in this area for respondents aged 65 and older – many can’t do simple interest calculations.

How Long Will it Take to Pay Off Debt?

That’s something else any consumer with credit card debt should know, so the authors posed this as their second of three questions:

You owe $3,000 on your credit card. You pay a minimum payment of $30 each month. At an Annual Percentage Rate of 12 percent (or 1 percent per month), how many years would it take to eliminate your credit card debt if you made no additional new charges?

A)     Less than 5 year;

B)      Between 5 and 10 years;

C)      Between 10 and 15 years;

D)     Never, you will continue to be in debt;

E)      Do not know;

F)      Prefer not to answer.

Slightly more than 35 percent of respondents knew that making the minimum payment amounts to an endless cycle (choice D). That’s it. The remainder show a less than solid grasp of debt literacy on this question. Hopefully they’ll do better with the final question.

Interest, Time and Money

You purchase an appliance which costs $1,000. To pay for this appliance, you are given the following two options: a) Pay 12 monthly installments of $100 each; b) Borrow at a 20 percent annual interest rate and pay back $1,200 a year from now. Which is the more advantageous offer?

A)     Option (a);

B)      Option (b);

C)      They are the same;

D)     Do not know;

E)      Prefer not to answer.

Only seven percent got this question correct. “Most chose a) even though the stream of payments to finance the purchase of an appliance at $100 per month in (a) has an APR of about 35 percent versus the 20 percent in option (b),” write the authors. Personally, this question threw me. As I read it, no interest is implied by choice a). But perhaps I’m missing something.

Demographics of the Debt Illiterate

The study authors found that debt illiteracy is indeed widespread. Respondents 65 and over showed the least debt literacy on the first question, while younger subjects (under 30 years of age) tended to get the first question correct but miss the final two. Gender and race divisions emerged, as did those between married respondents and unmarried. Among the unmarried, it is interesting to note that those who list as being divorced, separated or widowed performed at a lower level than those who had never been married. Surprising no one, respondents with higher income (particularly those earning $75,000 per year or more) scored higher than those in lower income tax brackets.

But Who Thinks They’re Literate?

On a scale from 1 to 7, where 1 means “very low” and 7 means “very high,” the study authors asked respondents to rate their financial knowledge. The average overall score was 4.88, and most considered themselves to be at least above average. Over half of those surveyed marked themselves as a 5 or 6, while only a wink over 10 percent actually chose 4 or lower. Rankings tended to mirror the demographic groups found in the three-question knowledge portion of the survey, but there were two notable differences. In particular, the over 65 age group rated themselves highly but scored lower at an average of 5.3, while the divorced/separated/widowed did the same but clocked in at only 4.79. Again – surprising no one – those who rated themselves high on average had higher incomes and accumulated wealth.

Four Clusters, Four Levels of Debt Literacy

The authors identified four distinct groups among the survey respondents. On one end of the scale are the “in control” group, comprising 26 percent of the sample. They are “firmly engaged in the traditional financial system. These individuals all have credit cards, but do not carry any revolving balances. They have relatively high (but not the highest) levels of experience with mutual funds, stocks, and bonds. They also had the highest incomes. On the other end are “fringe” users who partake of alternative financial services more often, such as payday loans, tax refund loans and pawn shops. Their likelihood of having ever invested in a stock, bond or a mutual fund—or held a mortgage—is about one fifth that of the “in-control” sample.

The middle groups make up what the authors claim to be 43 percent of Americans. The “borrower/saver” group (12 percent) has “the highest level of experience with savings and investments of any of the four clusters, with 98 percent having experience with savings or CD products, 83 percent owning mutual funds, 83 percent owning stocks, and 65 percent owning bonds or savings bonds. They are more extended than the “in control” group in that 95 percent carry revolving credit balances. The final 31 percent are the “overextended” group, who have “less experience with savings and more markers of extended credit.” They typically only pay the minimum on credit cards and have much more experience with penalty fees and much less with stocks and bonds. The authors consider this group to represent the “average American.”

Know Your Debt Level

This is the final question the authors asked participants:

Which of the following best describes your current debt position?

A)     I have too much debt right now and I have or may have difficulty paying it off;

B)      I have about the right amount of debt right now and I face no problems with it;

C)      I have too little debt right now. I wish I could get more;

D)     I just don’t know.

In November 2007 when the data was initially collected – barely predating the recession – around 40 percent of respondents had a negative relationship with debt. It seems likely that the numbers would skew even higher.

Lack of Education Will Cost You

That’s exactly what is found with Americans in credit card debt. Those who the authors found to be less financially knowledgeable tended to pay higher fees and finance charges. In fact, the authors estimate that a third of the costs such consumers pay on credit cards are a direct result of a paucity of debt literacy. In total, credit card holders paid $26.8 billion in penalties. Those less educated financially educated make up about 28.7 percent of the cardholder population, but account for a whopping 42 percent of those charges.

Richness of financial experience and a healthy amount of financial and debt literacy are the true recipe for accumulating wealth and approaching credit repair. Considering what Lusardi and Tufano found in their study, this “widespread lack of financial skills” is something America should be concerned about. Making financial education a mandatory part of school curriculums everywhere would be a good start, because what you know is more than worth its weight in gold.

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