What is interest?
Everyone above the age of 10 has heard of interest, but most of us do not take enough interest in interest despite the huge way this simple concept affects our everyday lives.
Anyone who has opened a credit card, taken out a loan, or opened a checking/savings account has been impacted by interest. The question is, do you know how interest works and how to use it to your advantage for Money Saved?
If not, you’re in luck, because that’s what we do at Money Saved is Money Earned! We save you money!
Read on to learn about interest and how it impacts various financial tools that you might be using or thinking of using.
What Is Interest?
The concept of interest is simple. You wish to purchase something but don’t have the necessary funds, so you establish an agreement with a bank, credit card, or some other lender. You get the money then must pay the loan back over a period of time. The extra compensation, the interest you pay, makes the loan worthwhile for the lender. You (the borrower) make a payment every month with interest until the loan is paid off.
Simple right? Not so fast.
This is the point where most people forget about interest, after the loan is acquired and their monthly payment is established. If you just want to make your monthly payments and forget about it, feel free to stop reading. However, if you like Money Earned through Money Saved, keep reading for a more in-depth view of interest (and for how you can save major moolah!).
Many things determine your specific interest rate on various types of loans. Your credit score (and the elements that make up that score) is the biggest factor lenders consider when establishing interest rates for personal loans, credit cards, and mortgages. This is why it’s so important to utilize credit responsibly, as it really affects your ability to gain new credit as well as your interest rates. Whatever your specific interest rate, it’s important to understand how lenders calculate interest and what percentage of your payments go to interest.
This is very important, and something many people do not understand!
Let’s take a look at a few different kinds of loans and discover how interest can affect the money you pay. Understanding how interest is calculated, as well as how you can cut down on the amount of interest you pay, is a huge step in having Money Earned through Money Saved.
Teaser: On the other hand, interest can also make you big money through investments (jump ahead to checking/savings accounts and investments to see how).
Understanding Interest on Debts
First let’s talk about mortgages, the type of loan where you’ll typically pay the most interest. With a mortgage, people often make the mistake of thinking that their payment is going mostly to the principal (loan balance).
Especially in the beginning, a significant portion of your payments goes toward the interest, not the principal!
You may not know this, but with a standard mortgage, the interest is calculated monthly. The amount of interest versus principal you pay with each monthly payment can be easily calculated through an amortization schedule calculator, which may also be referred to as a mortgage payoff calculator.
While these tools are readily available on the internet and often offered by lenders, not many people actually do one.
The numbers are staggering.
Let’s say you just bought a house. You have good credit and little debt, so you landed a 30-year mortgage with a fixed interest rate of 4%. To makes things simple, let’s say you put 20% down and have a conventional loan (a 20% down payment eliminates mortgage insurance, which will add even more to the monthly payment). The balance of your mortgage is $200,000, your yearly home insurance is $500, and your taxes are $3,000. You just made your first payment of $1246.50 (PITI). If you take out taxes and insurance, the payment going toward the loan and interest is $954.83 (PI).
Want to know where your money is going?
You just made your first mortgage payment, and a whopping $666.67 (or 69.8%!) went to…
You guessed it, JUST INTEREST!
Your first payment (PI) will show $288.16 toward the principal, and $666.67 to interest (don’t forget you also have to pay taxes and insurance).
And it doesn’t get any better any time soon.
Then, you’ll notice that the first month where most of your payment (but not much more) goes toward the principal is month 153 (highlighted in green), or 12 years and 9 months into the mortgage!
FOR ALMOST 13 YEARS THE LENDER IS TAKING MOST OF YOUR PAYMENT FOR INTEREST!!!
If the fact that most of your monthly payment is headed toward interest for almost half of the life of the loan isn’t enough, how about the actual amount of interest paid over the total life of the loan?
Sit down and hold onto something. Seriously.
If you only stick to your mortgage payment every month for 30 years, you will have paid back a $200,000 loan along with…an additional $143,739 in interest!
The total cost of your home over 30 years?
It’s okay, take a few deep breaths.
I promise buying a home is still totally worth it in most cases (remember a home is something that typically appreciates), but it is probably the most expensive investment you will make in your life due to the interest you’ll pay. But it doesn’t have to be quite so bad.
Don’t believe me? Here’s the deal.
Think of it this way. You really have two loans you’re paying with a mortgage: the principal balance (principal loan) and the interest (interest loan). The principal is a fixed amount, but the interest you’ll pay can be variable, depending on you.
Here’s how you can reduce your interest loan.
Every regular monthly payment is paid to both the principal and interest loans, but anything above and beyond the regular monthly payment is paid to the principal loan only. This means an extra payment of any amount will lower your principal, thus lowering the amount that interest is calculated on. Lowering your principal balance lowers the amount of total interest you pay and the total amount you’ll pay for the home.
Want to know something else? The faster you pay the principal loan amount down, the more interest you’ll save (less balance means less calculated interest). This means that a larger amount of interest will be saved by making extra principal payments at the beginning of the loan when the balance is higher. Now we know it’s difficult to make extra payments right after you buy a house (there are A LOT of unforeseen expenses, believe us!), but if you’re able, making extra payments in the first 5 years of the loan will give you the biggest savings in interest.
Let’s look at a few examples.
First, let’s look at the power of making an extra payment at the beginning of the loan. Let’s say you pay a double payment the first month. Using the example above, you would pay your mortgage payment of $1246.50 plus an additional $1246.50 toward the principal. If that was the only extra payment you made over the 30-year life of the loan, you would end up paying $140,891.78 in interest. The total cost of your home is now $340,891.78 (compared to $343.739).
That one extra payment saved you $2,847.22 in interest! ONE PAYMENT!
Still not convinced?
Let’s look at something more substantial. Let’s say you make an extra mortgage payment every year. That’s an extra $1246.50 going toward the principal every year. Over the life of the loan, making an extra mortgage payment every year would result in you paying $115,077.36 in interest. Now, the total cost of the home is only $315,077.36 (compared to $343,739 when paying off the loan as scheduled).
These extra payments have now saved you $28,661.64 in interest!!!
Not only that, making extra payments reduces the life of the loan. With the scenario we just described, you would not only save almost $30K in interest, but you’d pay off your mortgage after only 24 years and 10 months!
Another option is to start making extra payments every month in a smaller amount, such as $100 or $200. This will result in even more interest savings and reduce the loan term faster. In this scenario, every month your principal balance is going down, which results in savings in interest on a monthly basis. This method is what has allowed me to save significant time and money on my mortgage after 5 years.
The scenario we described may seem like a lot of money, but tightening your belt and making 25 extra payments (1 per year) of $1246.50 (totaling $31,162.50) toward the principal saves you almost $30,000 in the end.
What could you do with an extra $30K?
Now let’s talk about credit cards, the loans that most people will pay interest on.
Credit cards are a little different because they are revolving credit, meaning that the amount of credit extended can be borrowed again once paid. They are also different in that the interest on any balance carried is charged daily.
However, the method used to calculate this daily interest is pretty confusing. Let’s start with the interest rate, which is pretty straightforward. Each credit card has an APR or annual percentage rate. To get the daily periodic rate (DPR) used to calculate interest, simply divide the APR by 365 days.
Here’s where it gets tricky. Credit card lenders use something called average daily balance to calculate how much interest you owe because your balance fluctuates throughout the billing cycle. Calculating the average daily balance is extremely complicated, so for now we’ll give a very simple example.
Let’s say you buy something for $500 on day 1, then something for $300 on day 15, then pay $200 on day 25 of a 30 day billing cycle. You have 14 days with a balance of $500, 9 days with a balance of $800 ($500+$300), and 6 days with a balance of $600. Average daily balance would be calculated as follows:
(500×14) + (800×9) + (600×6)
7,000 + 7,200 + 3,600 = $17,800
$17,800/30 = $593.33
Average Daily Balance = $593.33
To calculate the interest owed for this hypothetical billing cycle, simply take the average daily balance and multiply it by the daily periodic rate, then by the number of days in the billing cycle.
For example, let’s say you have an APR of 15% (about the national average).
0.15%/365 = 0.00041096
DPR = 0.00041096
$593.33 x 0.00041096 = 0.2438
Daily Interest = 0.2438
0.2438 x 30 = $7.31
Total Interest = $7.31
The good news is that even though interest is calculated daily, the interest is not charged to you if you pay your balance in full on or before the due date. This is because you get a grace period with credit cards. There is a right way to pay your credit card if you want to take full advantage of this grace period. Unfortunately, most people don’t pay their balances in full and are charged interest daily beginning with the initial balance for the statement period.
But wait a minute? We just did an example and the interest was only $7.31?
While $7.31 doesn’t seem like a lot of interest, it does add up.
Let’s look at a different example. Credit card companies calculate the minimum monthly payment as a percentage of the current balance (usually around 2% or 3%) or as a minimum fixed amount, whichever is greater. A common minimum monthly payment for a lower balance is $25. A reasonable amount. However, if you only pay the minimum payment on your 15% APR credit card and you have a balance of $500, it will take you two years to pay it off and cost you $79 in interest!
Two years to pay off a mere $500? That’s ridiculous!
But $500 isn’t a very big balance, what if you rack up $5,000 on that same card?
Let’s say the best case scenario, the card issuer charges only 2% of the balance as the minimum monthly payment. Notice how the minimum payment changes as the balance changes? This gives you an idea of just how much you would be paying on your credit card balance with these numbers. You’ll also notice that you’re paying more toward interest per month than toward your balance (just like a mortgage). However, the biggest thing to note is the total amount of interest you’d pay and how long it would take you to pay off $5,000 with the schedule shown above.
Ready for it?
If you only paid the minimum payment on the balance for a credit card with a 15% APR, you would end up paying $6,973.68 in interest!
Not only that, it would take you 264 months, or 22 years to pay it off.
Absolutely, unequivocally do not stick to minimum payments on credit cards! In fact, credit cards charge so much interest that they are only beneficial as a financial tool if you pay your balance every month. If you pay your balance in full every month or make a few smaller payments resulting in the total balance throughout the month, you won’t pay a dime in interest and can enjoy some pretty good benefits. Rewards credit cards are a great way to earn cashback or travel hack.
Whether you pay off your balance every month, or simply make large payments toward your balance, but sure to pay off your credit cards as fast as you can to avoid potentially paying thousands in interest.
Personal loans are a big category and can vary greatly depending on the type of loan. However, there are some basic things to keep in mind when you are looking at taking out personal loans, and as always, understanding that interest is key to Money Earned through Money Saved.
Technically, everything already mentioned (mortgages, credit cards) are also personal loans, but for the purposes of this post, personal loans refer to smaller amounts of money that will be paid back within a few years.
Thus, we’re talking about things like auto loans, personal lines of credit, home equity loans, as well as any other smaller balance loans. It’s important to remember that terms and conditions, as well as the types of personal loans offered, will vary by the financial institution.
The following information is meant to serve as a guideline in helping you to understand the various options out there and how they are impacted by interest.
Auto and Recreational Vehicle Loans
Let’s start with auto and other recreational vehicle loans (boats, motorcycles, RV’s, etc.). Like credit cards, the interest on auto and recreational vehicle loans is calculated daily, so the faster you pay off the loan the less interest you will pay. You may be fresh from reading about credit cards and thinking you’d be in big trouble with interest on an auto loan, but the good news is most loans for vehicles have relatively low APRs (compared to credit cards).
Interestingly, vehicle loans are very different from credit cards in that the interest rate varies depending on the year of the vehicle. Typically, each lender will have 3 or 4 categories for vehicle years, with a range of interest for each category depending on your credit score and income/debt ratio. One thing to note, the APR will actually INCREASE for older vehicles. For example, take a look at the interest rate table for auto loans from my credit union.
As you can see, the older the vehicle the higher the APR range for interest. This may seem odd, but there are a couple good reasons for why older used vehicles have higher interest rates. First, the older the vehicle the less it is worth (depreciation) and the less the resale value. This means if you default on the loan and the vehicle is repossessed, it’s unlikely the lender will make their money back by selling it.
The second reason is also simple: lenders want you to buy new cars!
Offering lower interest rates for new car loans gives people an incentive to buy a new car because they may think the interest savings will offset the higher price of the new vehicle.
Don’t be fooled.
You can save a ton of money by NOT buying a new car, so unless you have an outrageous APR on your auto loan you won’t save anywhere near enough in interest to offset the higher purchase price of a new vehicle.
Overall, the interest you pay on a vehicle loan will be much less than on credit cards or mortgages, but that does not mean you should let the lender (or dealership) talk you into taking the maximum loan they’ll give you, along with a longer term in order to fit your budget. The focus should not be on fitting your budget (by any means necessary), but on how long your loan is and how much interest you’ll pay (don’t forget cars only depreciate in value). As with any loan, the longer you’re paying on it, the more your hard-earned money will go to interest. Go for shorter-term if you can, and try to pay extra as often as you can to decrease the interest amount even more.
Home Equity Loans
Now let’s talk about home equity loans (often called second mortgages). Home equity loans are funds borrowed against the equity in your home. In other words, if you owe less than what your home is worth, you have equity that you can use to access more funds. Borrowing against the equity in your home also means the lender uses your home as collateral, meaning that if you default on the loan the lender can take possession of the home in order to recoup their investment.
Foreclosure is a major risk when borrowing against your home, so don’t overstretch yourself! (The interest rate is very attractive for home equity loans, but DO NOT use your home as an ATM machine!)
Generally, there are two types of home equity loans offered: fixed amount and line of credit. A fixed amount home equity loan is when you borrow a specific amount and is similar to a mortgage in that you have a fixed interest rate and payment amount. Interest rates for fixed amounts are generally similar to that of mortgages, and the amount you can borrow depends on how much equity you have in your home. The impact of interest will be greater the larger the loan and length of repayment, similar to a mortgage. For example, take a look at this table for a home equity loan of $80,000 with an APR of 5%.
Even though $80,000 is not a huge amount compared to a mortgage, the amount of interest paid over 10 years is still over $20k. Of course, paying extra toward the principal every month will significantly decrease the interest amount, or paying back the loan over a shorter term (fewer months). Take a look at the same loan amount over 96 months (8 years). Although the payment is higher, you save over $4,500 in interest!
Home Equity Line of Credit (Heloc)
On the other hand, a home equity line of credit is more like a credit card. You still use the equity in your home to access the funds and use your home as collateral, but in this case, you have a maximum credit line you’re approved for and use it as needed up to the approved amount. As with credit cards, you’ll pay interest on any balance you carry.
Again, use the funds wisely. Do not use this credit line as an ATM for unnecessary expenses. This type of loan comes in handy for purchasing big-ticket items, or for paying off items with a high-interest rate. For example, you might use a HELOC (as low as 3.9%) to pay for a credit card with a high-interest rate (12-16%).
However, this type of loan is different than credit cards in that you’ll generally have a variable interest rate (which could increase or decrease at any time, so watch this). You also may have to pay an annual fee.
No matter what type of home equity loan you’re interested in, the larger the amount and the higher the interest rate the more interest you’ll pay. Also, similar to other loans, the more you pay toward the principal balance, the less interest you’ll pay overall. In general, if the loan amount is small and the length of the loan is short, you’ll pay less interest even if only making minimum payments. However, if the loan is a larger amount and for a longer-term, start making extra payments as soon as you can afford to. This will significantly decrease the interest paid and allow you to have Money Saved through Money Earned.
A home equity line of credit is a good option as a backup resource for emergency situations, but should not be used as an ATM.
Personal Lines of Credit
Personal lines of credit are just like the home equity line of credit described above, except they are not based on your home equity. You are approved for a line of credit that you can utilize whenever you want up to the maximum amount, at which time you’ll need to pay the balance down if you wish to use more credit. Unlike a line of credit home equity loan, personal lines of credit often have higher interest rates (14-16% APR), which can make them very expensive if you carry a balance (see credit cards). They also typically have a variable interest rate which will change with the changes in the economy. Personal lines of credit are also like credit cards because interest in calculated using the average daily balance. However, unlike credit cards you are not given a grace period to pay off the loan, meaning any balance you carry will accrue interest on a daily basis.
Furthermore, an advance from your line of credit will begin to accrue interest the day you transfer funds even if you don’t use the funds. So make sure you transfer only when you need it.
Personal lines of credit have a high-interest rate and no grace period. Therefore, paying a minimum monthly payment is a bad idea, as you’ll end up paying almost as much (if not more) in interest!
Smaller Balance Loans
Even though these loans are for smaller amounts, they are worth mentioning because they can still cost you a great deal in interest. These loans are available for any personal use and are dispersed either to your bank account or as a check. They are for small amounts (ex: $5,000) and for shorter terms (ex: 36 months). They also have higher fixed APRs (12-14%), which means you’ll pay a lot in interest if you only make minimum payments (just like with credit cards and personal lines of credit). Although these loans have higher interest rates, the shorter term of the loan somewhat mitigates the amount of interest you’ll pay.
Summary of Personal Loans
As you can see with these examples of various types of personal loans, there are several factors that affect the interest you’ll pay.
The first is the APR, or interest rate. The higher the rate, the more you’ll pay in interest.
The other is the length of the loan. The longer the length of the loan, the more you’ll pay in interest. Thus, a loan that is longer-term but with a lower interest rate may yield similar interest amounts to a shorter-term loan with a higher interest rate.
Each loan is different and should be considered individually based on the terms. However, one idea is constant: making extra payments. Making extra payments toward the principal will pay down the balance faster and greatly reduce the interest paid, no matter the terms.
It’s also worth mentioning that there may be other types of personal loans out there, such as credit builder loans, that you might utilize. However, no matter the loan the factors that affect interest will be the same.
Bottom line, the less you borrow and the quicker you pay it back, the more you’ll save on your borrowed money.
Student loan debt is fast becoming a crisis to rival credit card debt. Currently, more than $1.48 TRILLION is owed by about 44 million current and former students in America.
This means young people are saddled with $20k, $30k, $50k, even $100k in debt by the time they graduate before they even think about buying a car or a house.
But what are you supposed to do? You have to get an education somehow, right?
While there is not nearly enough education out there on the fine print of student loans and how to minimize the debt you do have, the focus of this post is interest (don’t worry, we will have a post all about student loans!).
You know what really irks us about student loans?
Here we have a bunch of kids with little to no training or experience about how credit works taking out HUGE amounts of loans because they have no other means to pay for school. The worst part is that students can get loans for everything, all at a hefty interest rate. In fact, many students use their loans for far more than legitimate education and living expenses (Cancun, anyone?) without realizing they’re racking up serious debt. Basically, lenders are taking advantage of financially naïve kids.
Let’s look at some Federal Direct Student Loan rates.
While these rates don’t seem too high compared to some of the ones we’ve been showing you, 6 or 7% is a lot to pay for people fresh out of college without much income or savings. As a result, most people pay off student loans with minimum payments every month (or defer them), and you should know by now how that usually ends up.
Take a look at some examples (found at Navient). You can also use a customized repayment estimator at StudentLoans.gov.
As you can see, even with low to mid-level (compared to credit cards) interest rates the amount of interest you’ll pay over 10 years is pretty substantial. As always, the best way to reduce interest paid is to pay extra toward the principal as often as possible. This should especially be a focus once you have a stable job, and paying off student loans should be a priority BEFORE accruing more debt.
But this isn’t even the worst thing.
Most people know that student loans don’t begin accruing interest until you’ve graduated, and you’re usually allowed a 6-month grace period, right?
Not always. Did you know that some student loans start accruing interest when they’re dispersed? Your “grace” period is really their harvest period!
This means your loans may begin accruing interest when you get them, not when you graduate!
If you have Direct Unsubsidized, FFELP Unsubsidized, Direct and FFELP PLUS, or Private loans check your statements, because your loans are likely accruing interest as we speak. This means you may have several years of interest built up on your loan before you even start paying it back!
Don’t worry too much, though, you can begin paying your loan back the day after you obtain it. If you can afford to while going to school, a $50 or $100 payment each month will substantially reduce the interest you pay by the time you graduate. Or better yet, don’t take out as many loans in the first place!
Unfortunately, many people are backed into a corner when it comes to student loans, and they have to take whatever options are given to them. Despite the limited options, there are some things you can do to reduce the amount of interest you’ll pay on student loans.
First, take out as few loans as possible, and only use loans for school-related expenses.
Next, DO NOT defer your loans unless absolutely necessary, as interest will still accrue on them. When you do begin to pay back your loans, make more than the minimum monthly payment if possible.
Third, and most importantly, make paying off your student loans a priority BEFORE you look to accrue more large ticket debt items. You’ll soon need a car to commute to your new job, and maybe you’ll want to buy a house soon after.
While student loans may be necessary for many of us, they don’t have to cripple your financial situation. Keep the loans low, and pay them off fast. If you can, begin making payments while you are still in school.
Understanding Interest on Assets
Now that we’ve beaten you down with all the ways that interest is killing you slowly (just kidding…but seriously), let’s talk about some ways that interest can actually work in your favor.
The first is with basic checking and savings accounts. You may not realize it (because it’s generally very small), but many checking accounts and all savings accounts actually earn interest for you. In fact, if your checking account does not earn interest, we recommend putting the extra amount in a savings account or finding a bank with an interest checking option so your money doesn’t sit idly.
Yes, there is hope!
You may be scratching your head at this point, thinking “Isn’t interest something a lender gets for letting people borrow their money?”
You’re absolutely right. Astute observation.
Here’s the deal.
When you open an interest checking or savings account, the bank pays you a small amount of interest every month (called the dividend) because the bank is using your money to make loans for other people.
While they’re paying you a small amount to borrow your money, they’re charging way more in interest to those taking out the loans (see mortgages, credit cards, and personal loans), so they’re easily able to pay you a small amount of interest AND make bookoo money!
Pretty cool, huh?
The thing is, you won’t get rich by having an interest checking or savings account. The amount of interest paid each month/year is simply too small to amount to much unless you have hundreds of thousands of dollars in the account (and if you have that much it better be somewhere it can really work for you!).
The interest you’ll earn varies, but the average savings account is now around 0.06% APY, with some banks going as low as 0.01% APY. Also, you’ll typically need to keep a minimum amount in the account to avoid penalties.
Another thing to look for is how often the interest is compounded, or when you’re earning interest on interest. At best, interest checking and savings accounts compound daily, but they can also compound monthly or quarterly, or even less often. You can play around with compounding interest at http://money.cnn.com/calculator/pf/moneygrow/index.html and get a better idea of the interest you’ll earn when shopping banks and accounts, but generally, you’ll earn a couple bucks a year.
Not much, but it’s something.
Another option for parking your savings is to stick them in a high yield savings account.
This is a relatively recent trend, but there are an increasing number of online banks as well as traditional banks offering savings accounts that yield a much higher rate, anywhere from 1.8% to 2.25% a year.
Again, you’re not getting rich with these rates, but putting your money in a high yield savings account will provide you with a return much higher than a basic checking/savings account.
In fact, we recommend putting your emergency fund or other savings not invested and not immediately needed in a high yield savings account so you can get the most for your money while still having quick access to it.
I currently have my emergency fund parked in a high yield savings account with Ally Bank, but there are many options out there. Check out this article from The College Investor to see the best options out there and see if one is right for you.
Here’s the REALLY fun part. Finally, let’s talk about an area where interest can really work in your favor!
Most people think of a 401(k) or stocks when they think of “investing,” but there are many other options out there, each carrying various levels of risk. Some of these investment accounts can only be redeemed at a certain age (without a major penalty). However, a drop in the bucket today will become a giant tank of water by the time you retire. There’s nothing more difficult than being older and poor.
Investment accounts work like beefed-up versions of savings accounts. Basically, you lend your money to a bank or financial company, which then invests the money in the stock market and other ventures. Based on the market and type of investment account, you earn interest on your investment over a designated period of time.
However, investment accounts are one area where you can really make money off interest. In fact, investing is what smart wealthy people do and why the rich keep getting richer.
You see, truly wealthy people don’t just spend money, they use their money to make MORE money.
Eventually, you’ll even start earning interest on the interest of your investments for even faster earning. This idea is called compounding interest, and it’s the reason that wealth-building gets easier over time.
Seriously, Google what rich people do with their money and we guarantee almost every article will be about investing (go ahead, try it).
While we aren’t financial advisors here at Money Saved (as in, we don’t work for a big financial company), we do know that the best advice when it comes to investing is to start early and to think long-term. Making money from investing takes time and patience, and as self-made billionaire, Mark Cuban says, “There are no shortcuts. NONE.”
Need more proof?
How about the billionaire investment guru Warren Buffett? Buffett uses the buy-and-hold strategy, meaning he invests in good companies and holds onto the investment over a long period of time. In fact, Buffett advises AGAINST watching the stock market for every ebb and flow.
So, what kinds of investment accounts are there, and how can I get in on the action?
There are TONS of ways to invest, and the details of them all are way outside the scope of this article. With that in mind, let’s focus on the type of investment account that everyone on the planet should be utilizing, if not now, then definitely in the future.
Retirement accounts include 401(k)’s/403(b)’s (offered by employers), solo 401(k)’s, standard and Roth IRA’s, and a few others. The type of account will differ depending on the employer and situation, but most jobs offer enrollment in one of these plans as part of the benefits package.
Many people neglect to enroll and contribute to a retirement account when they are young, and understandably so (you want every cent of that meager check, after all). But, if you listen to nothing else on this blog, please listen to this.
ENROLL IN YOUR EMPLOYERS RETIREMENT PLAN AS SOON AS POSSIBLE!
Remember our good friend Warren? Start early, be patient.
Let’s take a look at some examples, shall we?
Suppose you decide to begin investing in a 401(k) at 25. You place an initial balance of $1,000 in the account, contribute $600 a year, and your employer matches 50% of your contributions ($300/year). Let’s also suppose that you expect to retire at 65, and the average annual return will be about 6%.
Wanna know how much you have at 65?
Yeah, you retire with $396,371 but do you see it? Do ya?
You and employer contributions = $67,861. Not bad.
Holy interest! $327,510!!!
I repeat. THREE HUNDRED TWENTY-SEVEN THOUSAND, FIVE HUNDRED, AND TEN. From interest!!!
Of your total payout, 83% of the money is from interest.
What if you start just five years later, at age 30? All other parameters being the same, here’s what it looks like at 65.
Investing the same amount per year, starting five years later and retiring at the same age, yields a significantly smaller payout.
Over 120k less payout, in fact. But the total contribution is only $13,445 less, what gives?
The answer? INTEREST.
Five years makes a huge difference when you’re talking about interest.
Remember, invest early, be patient.
No matter the investment, the money-maker will be in the interest paid. As evidenced by our example above (as well as the loan examples), the longer the money is invested, the more interest will be earned. Thus, the earlier you invest the more interest (and payout) you’ll earn.
Another consideration is the risk associated with the investment. Generally, higher-risk investments earn higher APRs, making you more money faster. But remember, more risk means a higher chance of losing money as well.
Ask your HR department or bank for recommendations/sponsored investment options to see what may be best for you at this stage of your life.
Moral of the Story
What is interest? Only one of the most important financial concepts to understand.
No matter who you are or what you do throughout your life you will be affected by interest at some point. It will be impossible to use a credit card, have a bank account, get a car, or buy a house without feeling the impact of interest in some form or fashion.
While interest is a necessary evil of conducting our financial lives, interest doesn’t have to completely govern your financial situation. Understanding and paying attention to the interest you’re paying on your debts, and doing what you can to mitigate it, will help you get ahead and pay off your debts faster.
On the other hand, interest can also work in your favor when you invest money into assets that accrue interest, such as retirement accounts.
If you take nothing else from this article, it’s that whenever possible you should focus on putting your money into things that EARN you interest rather than CHARGE you interest.
See, taking an interest in interest helps you have Money Earned through Money Saved in more ways than one.
Save big on your purchases and earn big on your investments!