Compounding: A Two-Edged Sword

We’ve all seen the IRA illustrations showing how a deposit of $2,000 per year for x years growing at y % results in lots of dollars at retirement. For instance, $2,000 per year for 30 years at 7% grows to almost $189,000. Not bad, since you only put in $60,000 over the years.

That’s an example of how compounding can work for you. Compounding is the mathematical concept of earning interest on interest. Einstein allegedly called it the “8th wonder of the world.” But as with many truths in life, compounding can also work against you.

Let’s consider the harmless home mortgage. Assume you have a $100,000, 30-year mortgage at 4.4%. Your monthly payment for principal and interest is right at $500, which is $6,000 per year. After 10 years of payments, you’ve paid out a total of $60,000. That should make a big dent in your loan balance, right?

Unfortunately, no. In the early years of any loan, most of your payments go to interest. In our example, after 10 years your loan balance would be down to only about $79,625. You paid out $60,000 but only reduced your mortgage by about $20,375. That’s depressing. I won’t even tell you the numbers over the full 30 years of the mortgage…

So how should we then live? Sell the home, get out from under the mortgage and live in a paid-for tent? Nope. There’s more to your home than looking at it strictly as a financial resource (or burden, as the case may be).

But we do need to realize that compounding works for us as savers, but against us as borrowers. So a very simple rule of where to put your money is where you’ll get the biggest bang for your buck. If you can invest your money at 5% but have debts charging you 12%, you’re probably better off paying down your debts. (Side benefit—you’ll sleep better, too.)

There are other factors to consider in any decision like this, but understanding how compounding works is a fine place to start. In many cases it makes good sense to make extra principal payments on your debts, when you can—even if the IRA illustrations are tempting to look at. To really maximize your retirement readiness, pay down your debts quickly and save for your retirement as well!

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About Mike Wilson

Michael L. Wilson, MBA, CFP®, CRC®, is the owner of Integrity Financial Planning. Prior to founding Integrity in 1998, he worked for two years as a faculty member at the College for Financial Planning in Denver, training other financial advisors. Mike has 10 years of experience in the mutual fund industry, having worked with Fidelity Investments and Invesco Mutual Funds. He holds an MBA in Finance from Baylor University. Learn more about his work at www.integrityplanner.com.
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