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February 2, 2014

Investment decisions have compound consequences

Underestimating the impact of compound growth on a household’s finances can lead consumers to make poor economic decisions, including borrowing too much and saving too little. The three main engines that drive compound interest on an investment made or a loan taken out are the amount invested or borrowed, the time horizon of the investment or loan and the interest rate earned or paid. The longer the time period and the higher the growth rate the greater the financial impact.

Since most major financial decisions such as saving for retirement or repaying a loan involve large dollar amounts, long time periods and relatively high growth rates, compound growth can have an enormous effect on an individual’s financial security. Even modest amounts saved can turn into substantial retirement nest eggs and small amounts borrowed can spiral into large debts over time.

Our preceding articles explained and demonstrated the positive impact of compound interest on saving and investing. For a saver who is receiving investment earnings, compound growth helps build wealth faster. Conversely for a borrower who is paying interest on a loan, compounding works against them.

Most consumer loans involve compound interest, yet many consumers fail to grasp the consequences of snowballing interest costs when they enter into these contracts. Absent a disciplined and aggressive repayment plan what may begin as a reasonable obligation can grow into an unmanageable payment burden. Improperly managed debt will almost certainly result in a damaged credit record and the beginning of a cycle of increased future borrowing costs on home, auto and other loans.

While much of the literature on compound growth is focuses on increasing saving, the reality for many, especially younger people starting careers and families, is that reducing debt payments may be the most effective way to increase net worth and improve long-term economic well-being. For many of these consumers, balances on student loans, car loans, mortgages and other relatively high-interest debt dwarf their holdings in financial assets. Therefore, the costs of carrying debt rather than the returns earned on investments will likely be a more significant determinant in building wealth.

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