When asked to name the greatest invention in human history, Albert Einstein simply replied “compound interest.”
Although attributed to him, I doubt Einstein really said that, but the sentiment is spot on! Compound interest is very powerful to your financial well-being, and the difference between simple and compound interest is something everyone needs to understand.
To illustrate, let’s look at it in the context of one of the hardest decisions people have to make financially; a home purchase. Within this decision is often the struggle over putting down a lot of cash or taking out a big mortgage.
Many people feel they must pay off their mortgages as quickly as possible. When they read the truth in lending document in their Mortgage estimate, they might see hundreds of thousands of dollars of interest to be paid to the bank over the life of a 30-year loan. So conventional wisdom would say – ‘avoid the loan and the loan interest!’, or at the very least, take a 15-year loan. With a 15-year loan, even though the payments would be bigger, the total amount of interest paid is less. At least you aren’t wasting all that money down the drain, the thinking goes.
However, the reality is quite a different story. By just taking the extra dollars you would have paid to a 15-year mortgage and invest it in a properly diversified investment portfolio, you could come out way ahead. Why? It’s simple.
Simple vs. Compound Interest!
First, an illustration of simple versus compound.
If you had a $100,000 5% Interest only Home Equity line of credit, you pay simple interest on this of $5,000 each year (5% of $100,000 = $5,000). Since you pay the interest off, the principal amount does not grow or compound, and the interest payment stays the same. Over ten years, you will have paid $50,000 in SIMPLE interest.
Alternatively, if you invest $100,000 in a 5% ten-year CD (If you’re under 30, I promise you 5% CD rates at one time existed!), this interest is compounded! Therefore, the first year you earn 5% of $100,000 or $5,000; But the second year, you earn 5% of $105,000 or $5,250; the third year you earn $5,512.50 and so on! The dollars earned grows as the principal grows. After the end of ten years, you would have $164,761, or $64,761 in compounded interest; a 29% premium of compound interest earned over simple interest paid of $50,000.
Next, let’s take an example of Roger & Simon to see who comes out ahead in the simple versus compound game. Roger will concentrate on paying down his simple interest loan as quick as he can, whilst Simon won’t worry too much, and will use compounding interest to help himself create wealth.
So, both Roger & Simon are buying a house with a $100,000 mortgage. Roger gets a 15-year mortgage, making big monthly payments. He’d like to invest, but since he has a big 15-year mortgage payment, he isn’t able to begin investing until his house is all paid off. Simon, on the other hand, gets a 30-year mortgage, and the money he saves on a smaller monthly payment, he invests every month for the next 30 years.
Roger will pay less interest and will own his house free and clear earlier, while Simon will have a smaller payment and gets to begin investing now.
Roger gets a 15-year mortgage at 2.98%, and Simon gets a 30-year mortgage at 3.81%.[i] The 15-year costs $690 per month. The 30-year mortgage payment is $467 per month.
Next, we take Simon’s savings from the 30-year mortgage of $223 per month and invest in a balanced mutual fund with a 7% average rate of return over 30 years. Roger will not save anything from the 15-year loan until the house is paid off, but then to catch up to the 30-year loan, Roger will start investing the entire $690 (more than 3X what Simon saves per month) every month for the remaining 15 years. So, let’s start the race and see where they end up.
At the end of 15 years, with the 30-year mortgage payment, Simon has over $71,000 in his investment account, but still has a decade and a half of mortgage payments to go. With the 15-year mortgage, Roger has no extra savings, but on the other hand, he owns the house free and clear. So now, Roger has a chance to catch up; he starts investing the entire $690 a month for the remaining 15 years.
At the end of the full 30 years, Roger had now been diverting the $690 monthly payments to his investments for 15 whole years, and now has over $222,000. But Simon on the 30-year plan has over $270,000! Both houses are paid off, but the 30-year plan wins! This doesn’t even take into account after tax savings on the payments, which usually makes the 30-year mortgage even more attractive!
So, one more example for all of you who want to put a huge sum of money down on a home to avoid mortgage payments altogether!
Let’s say Simon has the $100,000 in cash at the beginning to buy the home outright, but instead of putting all that money in his house, he takes a $100,000 30-year mortgage instead. He pays $467 in monthly mortgage payments and invests the $100,000 over 30 years at a 7% rate of return. So how does Simon make out at the end of thirty years?
Simon would have paid $168,120 in interest and principal over 30 years, but he would have over Three Quarters of a million dollars in the bank!
And that is the power of compound interest.