Compounding Interest And Debt Reduction

When it comes to personal finance, I love to do the maths because it can be more revealing than just words and concepts alone, and I get a little excited over numbers.

Compounding is one of those interesting calculations. You may have seen this example before, but I think it illustrates compounding well.

What would you take? $10,000 in the hand today or 1 cent/penny doubled everyday for a month.

If you choose to take the penny, this is how much you end up with after 31 days.

I admit that it’s an impossible example, but it I love the way it demonstrates the power of compounding. And while it may be a no brainer to some, the first time I read this it blew me away.

Take another slightly more realistic example. Just say that you decide to put away $50 a week for 18 years (as a uni fund, say) into an investment that gives an 8% return. At the end of the 18 years, you will have around $101,290. Just after the 16 year mark, the amount of interest earned will be higher than your contribution amount. (This example assumes that the interest rate remains at a constant 8% and does not  account for fees or inflation.) Check out www.fido.gov.au for online calculators if you would like to run some calculations for yourself.

So compounding works in our favour when we invest and when we build our savings. The key factor is time.

But compounding can also work against us when we have debt. And again the key factor is time. Interest on a loan compounds over time just as it does on savings, so the longer it takes to pay off a debt, the more interest you pay.

For example, a loan of $20,000 at an interest rate of 13% paid off over ten years will have monthly repayments of $298.62 and cost you $15,834.57 in interest over the term of the loan. Pay it off over 5 years and the monthly repayments will be $455.06 and and it will cost you $7,303.69 over the term of the loan. This will save you $8,530.88 in interest.

I’ve written before about how you can drastically reduce your mortgage and save huge amounts of interest by making small extra payments. Using the snowballing and snowflaking methods of debt reduction will also save you interest and help fight the negative impact of compounding interest on debt.

There can be an additional benefit to saving money on the interest on outstanding debts, rather than investing the same amount. The interest saved is tax free,  and as interest rates on debt are often higher than returns on investments, the interest saved could end up being higher than an investment return over the same period.

Note: This information is general in nature and not tailored to your situation. It is not financial advice. You should consult a qualified expert and read and consider the Product Disclosure Statement of any financial product before deciding on a course of action.