Think about what you would do if you threw a large party of 100 people and nine extra guests came. Not a big deal because you probably made too much food anyway. You decide to invite the nine extra guests as regulars to the next party. The guest list is 109 people.
However, at the next party what if those nine people each brought his or her spouse? You are a little panicked because the food may run a little short. But you pull it off – just barely. The invited guest list becomes 118.
So next time your party rolls around the original nine bring his or her spouse, and now his or her first born kid? It is not long until your original list doubles in size.
Are uninvited guests good or bad?
Sometimes these “additions” are good such as when you are trying to get more people to join your writer’s group or charity. Others are not as good such as when you have a bunch of relatives move in with you and they multiply. Things can get tight.
As in finance, these “additions” can be compared to interest rates. Some interest rates are good such as increasing your 401K or an investment in money market accounts or savings accounts. Others are interest rates that you pay on money that help you in life such as a student loan, a mortgage and a reliable car. But those interest rates tend to be low and fixed. Others are the interest rates you pay on credit cards, which tend to be higher.
Uninvited guests in finance
This is how I think of interest rates. A 9% interest rate in finance is not just a simple addition of 9 people every time to the party. This interest rate is “compounded” meaning that these nine people become regulars and then bring a few guests, children, more friends ….and eventually their pets.
Now you think to yourself, “How often am I going to have this party?” In the real world you can put it off. However when it comes to interest compounding, you have no choice. The interest can be compounded continually or periodically. That is up to the financial institution, but it is important as a consumer to understand how often it is done. One of the most common in credit card interest rates is quarterly. But that can still add up! Yes, be sure to read the terms and conditions with your credit card.
Rule of 72
You will see and hear the “Rule of 72” all over and it is a simplified approach to calculate how long it will take your “party” (original amount) to double in size. You take the number 72 and divide it by the interest rate (the multiplying party guest number). 72/9 = 8. In just 8 years your party size of 100 will double to 200.
You may say, “Eh, that is not so bad….” I will stop having parties before it reaches that point (aka pay off the credit card). But what if you can’t? What happens if instead of stopping your original guest list goes up (you spend more on the credit card)? If your uninvited compounded quests reach 18%, the original rate goes up much faster. 72/18 = 4 years that amount will double.
So I encourage you to get the lowest interest rate you can on homes and cars. Avoid high interest credit cards. Invest in high yielding investments and 401Ks. Lastly, make sure you know the uninvited guest number so that it is never a surprise.