Interest rates don’t seem like a crucial thing to learn about in your 20s or 30s. And learning the seemingly-complicated math of interest rates—specifically compound interest and discounting cashflows—might not seem like an accessible or important skill. Oh…but they are. One reason why I insisted on teaching this math in the early chapters of The Financial Rules For New College Graduates: Invest Before Paying Off Debt And Other Tips Your Professor Didn’t Teach You is that we need to demystify finance. I mean, it’s not a magic trick. Financial professionals are not wizards. In fact, you can learn the foundations of many of their “secrets” by opening up a spreadsheet and watching a few videos below. With a little effort, you should end up knowing what’s going on with your money better than most people. Better than most financial professionals, for that matter.
It starts with understanding simple interest, and we build from there. You probably know that if you borrow $1,000 from a buddy for one year at 8 percent interest, you will have to pay back $1,080 at the end of the year. In that sense, interest on money that you’ve borrowed means you have to work extra hard to earn enough every year to pay off your debts. The higher the interest rate, the harder it becomes. For instance, owing $1,000 on a credit card charging 22 percent in interest costs you about $220 on the $1,000 debt. That interest rate is like a backwards-moving monorail, and the longer you’re in debt, the further you are from your financial goals.
But the interest rate monorail, as I explain in my book, can work in your favor as well. Interest rates on your money—also broadly understood as “yield” and “return”—can move you forward when you are a lender or an investor. The money you lend or invest today grows into larger amounts in the future without you hardly even trying.
Investors can choose a slow-moving and safe monorail, historically earning 1 to 3 percent annual return, or a more volatile but ultimately faster monorail, earning above 5 percent per year.
I use the monorail metaphor to understand this phenomenon because wealthy people with the right approach to investing cannot prevent themselves from having more money in the future. Just by standing still. Just by doing absolutely nothing. Money just grows on money, pretty much all by itself, if we can get ourselves out of the way and let it.
I hope to inspire you to examine whether the monorail you are currently on—the interest rates that affect you and your money—moves you forward or whether it moves you backward. I hope you embrace the optimistic thought that even if right now you find yourself working twice as hard just to stay in one place on a backward-moving monorail, you can flip that switch. In the future, you could let yourself be propelled forward by the same monorail.
The mathematical power of flipping that switch is captured in the concepts of compound interest and discounting cashflows, which I’ll introduce and explain further in subsequent articles. As a preview though, I think the following two ideas we gain from compound interest and discounting cashflows are worth thinking about:
Compound Interest: If we managed to scrape together a nest egg amount of $5,000 to invest in an IRA at, let’s say, age 25, we could invest that until retirement age, at 65. If that $5,000 earned a compound return for 40 years at the reasonable rate of 6%, it would be worth $51,429, rounded to the nearest dollar. If it compounded for 50 years until age 75, at the high (but historically plausible) rate of 10% annually, it would be worth $586,954. That’s potentially life-changing. And it’s not magic or wizardry. It’s math.
Discounting Cashflows: If we knew we wanted to have a retirement portfolio of $1,000,000 at age 65, and thought we could achieve a 6 percent return between now (age 25) and then, this math concept tells us we’d need a nest egg today of $97,222 rounded to the nearest dollar (assuming we don’t add anything to the nest egg over time). If we could achieve an 8 percent return, we’d only need a starting amount of $46,031. If that’s flabbergasting, consider that if, instead of one lump sum you never added to for 40 years you instead made much more modest contributions every year until you retired, you’d only need to contribute about $6096 a year to reach $1 million by age 65. That’s a solid, but not outrageous, amount of money to gather year after year.
This is really what understanding interest rates, and interest rate math, helps us do.