It will continue to grow – whether it’s an asset or a liability

A couple of weeks ago I posted that if you invested $10,000 at a 10.7% annual return (the average annual return of the S&P 500), after forty years, that $10,000 would grow to over $580,000! You can see how those numbers easily change the more you invest. $100,000 compounding for 40 years at the same rate of return is over $5,800,000.

Compound interest is an amazing thing. Here’s how it works, with a simple example. Let’s say you invested $10 and each month it earns 10% interest. After the first month, it will be $11. The next month, the $11 will earn 10% interest and it will earn $1.10, becoming $12.10. This goes on and on and at the end of 12 months, your ten dollars will grow to $31.38, without you adding anything to it. When you use bigger numbers and longer periods of time, the growth is truly spectacular and makes it possible to retire without having saved everything you need to retire.

If this blows you away and excites you (it does me!), then it should be equally shocking to know that the same compounding is true for debt. $10,000 of debt kept around for forty years with a 10.7% interest rate will cost you over $580,000. Throughout our lifetimes, we likely have multiple debts that get us close to this number, even if we don’t keep any one of them around that long. Large student loans, large mortgages, home equity lines of credit, credit cards, and car loans all add up over time.

When it’s an asset, it feels like *magic*. When it’s a liability, we feel like we’re getting screwed.

So what can you do about this? Don’t use debt. For smaller purchases, save up. If it’s something you can wait a year to buy, take the total amount of the item you want to purchase, divide it by 12 months, and save that same amount each month before buying the item. If it’s a bigger item, like a car, it might take 24 months or 36 months. Regardless, divide the amount by a specific time period and set that money aside until you are able to make the purchase without debt.

Houses are a little trickier. They are often big-ticket items. Only buy a house you can afford (not more than 25-33% of your take home pay) and think about what it means to have a mortgage for 15 years or 30 years. Pay it off quickly. If you borrow $320,000 and have a 5% interest rate, the loan, over a 30-year period, will cost over $625,000. With a 15-year mortgage, the same $320,000 will cost $460,000. In either scenario, it’s a lot of money going to interest.

When considering borrowing money, ask yourself, is it worth renting this money at this interest rate for this item? The answer very often should be no.