I recall many years ago at a Junior Wall Street workshop (yes I really did attend one in my early teens) learning from veteran brokers and traders at the New York Stock Exchange, and hearing them tell me that the most important concept that a consumer can ever get their head around is the concept of compounding. As our conversation continued, they told me something that I’ll never forget.
But first, what is “compounding”, when it comes to your finances of course… According to the Merriam-Webster Dictionary, it is “interest computed on the sum of an original principal and accrued interest.” So basically that’s interest, earning interest on growing interest over time.
So, yes, compounding has major impact on both your debt and investments over time. If debts are in repayment mode, interest continues to accrue and the cost of goods and services purchased with credit goes up. For example, if the interest is calculated into a monthly payment for an auto or other installment loan, then we often never again pay attention to the amount of monthly interest being paid in addition to the principal cost of the car or other item. If interest is accruing, or being added to a credit card or revolving debt, then interest can make it harder and harder to get ahead of that particular debt because the interest on the current balance goes up every time the credit card balance goes up. It’s a very scary proposition and makes it oh so smart to just pay off credit cards monthly in full or to wait until the cash is available to purchase what we want or need. So consider debt the dark side of compounding, unless of course you’re the bank or person making the loan.
On the flip side, when it comes to investing, compounding interest is your best friend! This is a major positive for those who start saving earlier in life and benefit more as time goes on. Younger savers have a longer time horizon for their money to grow with the benefit of compounding interest and dividends. For those making consistent contributions to their investment accounts, the interest building on more deposits and the accrued interest is the beginning of building wealth. The good news is, anyone can benefit from compounding interest and it’s never too late to save more.
So, in regards to the wise advice that I’ve never forgotten about how compounding is the most important financial concept for consumers to understand; once that concept sinks in, it makes it harder and harder to ignore the damaging compounding that more and more debt can cause. Conversely, it makes it easier and easier to buckle down, pay off debt as soon as possible, and invest your savings wisely to benefit from the positive side of compounding. This is how you build lasting financial security.