Editor’s note: This post first appeared in Make Change magazine, an online personal finance site.
Interest rates don’t seem like a crucial thing to learn about in your 20s or 30s. And learning the seemingly-complicated math of interest rates – specifically compound interest and discounting cashflows – might not seem like an accessible or important skill. Oh…but they are. One reason why I insisted on teaching this math in the early chapters of The Financial Rules For New College Graduates: Invest Before Paying Off Debt And Other Tips Your Professor Didn’t Teach You is that we need to demystify finance. I mean, it’s not a magic trick. Financial professionals are not wizards. They really don’t deserve to be paid as much as we pay them. You can learn this by opening up a spreadsheet and watching a few embedded videos here. With a little effort you should end up knowing it better than 99% of people. Better than most financial professionals, for that matter.
It starts with understanding simple interest, and we build from there. You probably know that if you borrow $1,000 from a buddy for a year at 8% that you will have to pay back $1,080 at the end of the year. In that sense, interest on money that you’ve borrowed means you have to work extra hard to earn enough every year to pay off your debts. The higher the interest rate, the harder it becomes. Like owing $1,000 on a credit card charging 22% in interest creates an even harder headwind, costing you something like $220 on the $1,000 debt. That interest rate is like a backwards moving monorail, against which is it hard to get ahead, when you’re in debt.
But interest rates, as I explain in my book, can work in your favor as well:
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But here’s an optimistic thought: The monorail also moves the other way. Interest rates on your money—also broadly understood as Yield and Return—can move you forward. When interest rates work in your favor— specifically when you are a lender or an investor— your money today grows into larger amounts in the future without you hardly even trying.
For wealthy people, money they have today for investment simply grows into larger amounts of money tomorrow. They can choose a slow-moving and safe monorail, historically earning 1 to 3% annual return, or they can choose a more volatile but ultimately faster monorail, earning above 5% per year. Done correctly, this wealth-building requires little skill or effort.
I use the monorail metaphor to understand this phenomenon because wealthy people with the right approach to investing cannot prevent themselves from having more money in the future. Just by standing still. Just by doing absolutely nothing. Money just grows on money, pretty much all by itself, if we can get ourselves out of the way and let it.
I hope to inspire you to examine whether the monorail you are currently on— the interest rates that affect you and your money— moves you forward or whether it moves you backward. I hope you embrace the optimistic thought that even if right now you find yourself working twice as hard just to stay in one place on a backward-moving monorail, you can flip that switch. In the future, you could let yourself be propelled forward by the same monorail.
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The mathematical power of flipping that switch is captured in the concepts of compound interest and discounting cashflows, which I’ll introduce and explain further in subsequent posts. As a preview though, I think the following two ideas we gain from compound interest and discounting cashflows are worth thinking about:
Compound Interest: If we managed to scrape together a nest egg amount of $5,000 to invest in an IRA at, let’s say, age 25, we could invest that for the long term, let’s say for 40 years until retirement age, at 65. If that $5,000 earned a compound return for 40 years at the reasonable rate of 6%, it would be worth $51,429, rounded to the nearest dollar. If it compounded for 50 years until age 75, at the high (but historically plausible) rate of 10% annually, it would be worth $586,954. That’s potentially life-changing. And it’s not magic or wizardry. It’s math. It’s demonstrable when you learn compound interest math such as in this embedded video:
Discounting Cashflows: If we knew we wanted to have a retirement portfolio of $1,000,000 at age 65, and thought we could achieve a 6% return between now (age 25) and then, this math concept tells us we’d need a nest egg today of $97,222 rounded to the nearest dollar. If we could achieve an 8% return, we’d only need a starting amount of $46,031. That’s a solid but not outrageous amount of money to gather together in one’s 20s. The math required to do that calculation is introduced in this embedded video:
This is really what understanding interest rates, and interest rate math, helps us do.
Please see related posts:
Introduction to Compound Interest with Book Excerpt – part 2
Introduction to Discounting Cashflows with Book Excerpt – part 3
And buy my book here: The Financial Rules For New College Graduates
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