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Basic Finance 101: Compounding Interest

When it comes to buying real estate, many people tend to get a little overwhelmed by the financial side of things as they try to understand the short-term and long-term effects of the down payment, interest rate, points, and other financial factors. So, I thought I’d write a little series to explain some important financial concepts.

When you try to qualify for a home loan, lenders want to know your debt-to-income ratio. They calculate this by adding up all your monthly debt payments (car loans, student loans, revolving credit card debt, etc.) and dividing them by your gross monthly income (the money you earn before taxes and other deductions). Lenders’ primary goal is to make sure you can repay the loan. So, while it’s okay to have some debt, it’s best to have as little as possible.

To pay down your debt, the best approach is to consistently pay at least the minimum required to stay in good standing on all your loans. Hopefully, you have money left over, and if you do apply it to the debt with the highest interest rate. Also, try not to be tempted by credit card teaser rates, because when those zero percent offers jump to 24.5 percent a few months later, your bill will skyrocket.

Once you’ve paid off your debt, it’s time to start saving and this is where the power of compound interest puts you on an accelerated path to purchasing your own home. Albert Einstein called compound interest “the eighth wonder of the world.” He said compound interest is the most powerful force in the universe and the greatest mathematical discovery of all time. That’s pretty strong language for a guy who took his numbers seriously.

So what is this amazing force? Compound interest is the addition of interest to the principal sum of a loan or deposit. Said another way, it allows you to earn interest on your interest. Compound interest is the result of reinvesting interest rather than paying it out, so that interest in the next period is earned on the principal plus previously accumulated interest. The longer you allow the investment to grow by reinvesting the interest, the greater the magnification of this effect as compared to simple (non-compounding) interest.

Here’s an example. If a 25-year-old invested $1,000 on January 1, 2018 at 5 percent per year, then on December 31, 2018, the new balance on the investment would be $1050. A year later, the new balance would be $1102.50 (the 5 percent interest was earned on $1050), and so on. After 40 years, the original $1,000 would have grown to $7,040. Without compound interest, the original $1,000 would have only grown to $3,000 ($1000 original investment + $50 per year x 40 years).

Here’s a fun fact. In 1626, Europeans bought Manhattan Island from the local Indians for about $29 worth of beads and other goods. If those Indians had the opportunity to invest their $29 at an annual compounding rate of 5 percent, they would now have $5,262,336,110. Some investments have monthly compounding. If that were the case for the Indians, they’d now have $8,118,216,133. Whether it’s $5 billion or $8 billion, it’s a lot of dough.

Now, I recognize that most of us can’t wait 392 years for an investment to grow; however, even over a shorter period, money can grow at an impressive rate, especially if it compounds monthly, daily, or even continuously, and there are investments that do this.

Recognize that compound interest can also work against you. If you are in debt, especially revolving credit card debt, your debt will grow just as quickly as your investment would, which brings to mind another Einstein quote about compound interest, “He who understands it earns it. He who doesn’t pays it.”

If you have questions about real estate or property management, please contact me at rselzer@selzerrealty.com or call (707) 462-4000. If you’d like to read previous articles, visit my blog at www.richardselzer.comDick Selzer is a real estate broker who has been in the business for more than 40 years.