April 22, 2024

How does compound interest actually work?

“The eighth wonder of the world is compound interest,” said the proverb. As the saying goes, “He who understands it, earns it; he who does not, pays it.” The name Albert Einstein.

Even though Einstein was a genius, he was stuck in debt for a significant portion of his life. On the other side, Warren Buffett, a well-known financial guru, is known for praising compound interest as the most powerful ally that an investor can have. He attributes a significant portion of his riches to this principle:

My riches is the result of a variety of factors, including being in the United States, having some fortunate genes, and compound interest.

Your thoughts are probably going something like this: “That’s nice, Gillian, but why are you giving me a bunch of quotes about money?” The answer is TikTok, or more particularly, a video that has gone popular and continues to circulate, which asserts that you can pay off your mortgage in five years by spending one dollar each day.

You are not able to, as a spoiler. But it also opened my eyes to the fact that compound interest is a concept that is widely misunderstood. Being able to comprehend how to use it to your advantage is literally beneficial, despite the fact that it is neither good nor harmful. So, here is a brief summary of the information that you need to be aware of.

What exactly is the concept of compound interest?

Compound interest refers to the interest that is earned or charged on both the initial principal amount (the amount that you have borrowed or have in your savings account) and any interest that has been earned or charged in the past along with the principal amount.

Imagine you have a savings account that has a balance of one thousand dollars and an interest rate of ten percent.
The total amount you would have after the first year would be $1100 ($1000 plus $100 in interest).

Not only would you get interest on the initial $1000, but you would also earn interest on the $100 interest that you earned in the first year (that is, ten percent interest applied to your $1100 of savings), which would result in a total of $1210 ($1100 plus $110 in interest).

Over the course of time, this effect of compounding continues. The money in your savings account will increase in value over time if you have an account that earns interest.

How compound interest works when you have a mortgage:

Compound interest is calculated by first adding interest to the principal sum of your loan, which is the amount that you have borrowed, and then subtracting the amount that you have paid back.

After that, you will be charged interest on the remaining balance of your debt, and this will be added to the total amount of your loan, so increasing the total amount of your loan as your repayments are applied.

It is because of this that the initial few years of your house loan feel so challenging; it is like trying to sprint on ice and going nowhere very quickly. However, as time passes, the principle amount that is owed decreases, and the amount of money that you are able to return begins to make a difference in the total amount of money that you owe on your apartment or house.

Strategies to minimise compound interest on your home loan:

It is likely that the most successful method for achieving the goal of being mortgage-free is to pay down the principle of your loan as quickly as feasible.

Let’s take a look at an example that is comparable to the one that was discussed in the TikTok video that went viral:

Consider the following scenario: you have a mortgage of $500,000 with a 5% interest rate and a loan period of twenty years:

The total amount of time it will take you to repay your loan will be twenty years if you make payments of around $3,300 per month, which is equivalent to $39,600 per year.

Over the course of this time period, you will pay a total of around $792,000, with approximately $291,950 being interest payments.

By making a payment of $1650 every two weeks, which is equivalent to half of your monthly payments, you will lower your annual payment to $42,900 from $39,600.

Because of this, you will be able to return your loan in just seventeen years and six months, which will save you around forty-one thousand seven hundred fifty dollars in interest and will also free you from debt two years and six months earlier.

Would it make a difference if you paid an additional dollar into your mortgage each day?

However, despite the fact that TikTok portrays the world as a strange and lovely place, it is not a suitable replacement for professional financial guidance.

By paying an additional $1 per day on our $500,000 mortgage, you will only be able to lower the length of time it takes to repay the loan to 19 years and nine months, which will save you around $5470 in interest. It is true that this is not a bad thing, but it is not a significant change, and it is a far cry from the assertion that adding one dollar every day will reduce the length of your debt from twenty years to just five years.

In order to “beat” compound interest, there is no magic trick that can be used. The amount that you pay back on your house loan will not change significantly if you make your payments more regularly, such as daily or weekly, unless you increase the amount that you pay back, as was the case in the example of the fortnightly repayment that was presented earlier.

The amount that you owe will decrease more quickly if you make bigger repayments, and the interest component of your repayment will be reduced as a result.

As a result, a greater portion of your repayment is applied to the principle amount of your loan, and your debt decreases at a faster rate. This is an example of compound interest working in your favor, rather than in the favor of your lender.

When it comes to avoiding compound interest, there are no hidden tricks.

With the option to refinance to a lower interest rate while keeping your repayments at the same level as before, you will be able to pay off your home loan in a shorter amount of time.

Completing the repayment of your mortgage as quickly as possible is the most efficient method for reducing the amount of compound interest that is accrued on your mortgage.

When you make additional payments on your home loan, you should make sure that you are informed of any penalties or fees that may be accrued.