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Financial Fluency Episode #18: The Dark and Light Sides of the Compound Interest Force

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Today I want to talk to you about compound interest.

This is something a lot of us hear when we first start learning about money, and in a lot of personal finance books it’s kind of called things like the eighth wonder of the world or the magic of compound interest, and we’re all kind of told to believe that if we can just get enough time behind our money, it will really make a huge difference in our life.

You can listen in below and Tweet it out here

It is true that the earlier you start investing in saving, the better off you are. However, lately – well, I say lately, I mean for the last decade – the truth is it has not been a very kind world to save in, in terms of the interest that we can get.

Interest rates have been rock bottom and almost zero in many places in the world, including the United States. It’s been so low to encourage borrowing and to kind of lube up the gears of the mechanism of the economy, so that people who are relying on savings and income from savings have really not been doing well.

It’s pretty much got to the point that if you don’t want to be losing money to inflation, you have to put it into something that gets more than your regular savings interest rates

What this usually looks like is investing it into the stock market. However, as we saw back in 2008, the stock market can be extremely volatile depending on different cycles and bubbles and things that go on in the economy, so a lot of people, understandably, get scared by that.

In the past people have said that the best way to use compounding is really in a way when there is not the risk of principal loss, so here’s the issue. A savings account does not have the risk of principal loss, you won’t lose your principal, your principal’s safe as long as it’s in an FDIC insured account and is under 250 thousand dollars. However, if you want something more than the less than one per cent that most people are getting in interest on their savings accounts, you have to do something much more risky and put your money at risk by investing it in something where there could be principal loss.

There’s huge potential for the principal loss that you could have in the stock market, but if you leave it in a savings account you are losing money to inflation every day.

So What’s a Person to do?

The positive type of compound interest is where you have money that is making money for you, either in a savings account at a super teeny tiny amount that’s actually losing money to inflation every year or you have it invested in some kind of other investment vehicle like:

  • A fund
  • Some kind of stocks
  • EFTs
  • Bonds, or
  • Annuities

There are a lot of these different vehicles that you can put money into, from which it’s invested.

The wisest way to do these things is to also get tax benefits from them, because that also helps offset the amount that inflation’s affecting them, so either you can do one of two types of tax advantaged accounts, one where you are taxed now and you pay nothing on the gains over time, or where you save taxes now, have that pre-tax dollar earning money for you, and then you pay the taxes at the other end. You can get more information on what these differences mean to your dollar here.

The Dark Side of The Force

All of this is thought of as the good kind of interest, and it is good, it’s positive and at least you’re going in the right direction. The way that compound interest works against you, the dark side of the force, is when you’re the one who owes money and are paying interest out while you get very, very little interest for loaning the bank your money. When you put money into a savings account, you are loaning the bank money. They are the borrower and you are the lender, but you get almost nothing for it. Tweet That!

However, when you borrow the money, say from a credit card company, they could be charging you anywhere from eight to 24 per cent, depending on what kind of credit card you have, what the APR is, what your credit history is and if you have any dings on that history like late payments or not making the minimum payment and so on. Those things all make it harder for you to get lower interest rates.

Right now because there are so few venues for us to use the positive side of the force in terms of compound interest, I think one of the biggest ones we can have is to mitigate the damage done by this negative interest.

How do We do That?

Credit buyingBy getting out of debt and paying off those high interest credit cards, paying off the highest interest first and going down the line from there.

A lot of us have multiple kinds of debt, and I’m including myself in this. I am by no means someone speaking as a fully debt free person. I have a mortgage, I have a car payment, there are times when I have balances on my credit card, and I know that the best thing to do with credit cards is to pay off the balance in full every single month.

If you are not there yet, make that the first goal. Get one credit card completely paid off, then work through the others, and once they’re all completely paid off, get in a system of paying it off every month, of not putting more on there than you will be able to pay off.

I do think there are ways to use credit cards as tools, but it’s so tricky to get into that situation in case something goes wrong and you don’t have your savings account built up. I also like to have a curveball savings where I keep savings for things that happen irregularly, but aren’t totally unexpected, things like car repairs, needing to replace things in your home, and also bills that aren’t monthly, but come up regularly, like car or home insurance.

It’s good to look back over the last few years and figure out how much those not quite monthly things have been, and make sure you’re setting that aside so it doesn’t go on the credit card.

A Personal Example

We’re keeping my car payment because it’s at 0.9 per cent interest which is lower than our mortgage. If we had no car payments, in one way it would feel like a lot more money every month because there wouldn’t be that extra bill, but at the same time it’s so low interest that it would actually make sense for us to pay off some of our mortgage before paying off that car payment.

We’re carrying that on for now, unless we get to the point where all of our other revolving credit is completely paid off and all we have are these installment type credits. Revolving credits are things like your credit cards, things that are consumer debt, and installment credit is things like car loans and student loans. These are things where you paid for something big, it’s relatively secured, they’re pretty sure, and it’s hard to get out of it. If you don’t pay your car payments, they can come and repossess the car.

In terms of credit, the things that are weighted most heavily are the revolving credit, which is basically your credit cards, so paying those off first before anything else makes the most sense.

That’s really what you can do right now to make the most of the current financial situation. We can’t get a whole lot of positive compound interest out of savings accounts, we can get some out of investing, but with some risk if we do it in a tax advantaged way, but the biggest wins most of us can get are to pay off our debt and not get into that negative cycle of giving the banks the compound interest from that.

If you’re ready to tackle your debt in a constructive way, you can check out my Debt Reduction Lab here In this mini-course you’ll going to learn my three step process for reducing your debt starting now.

My Favorite Debt Management Tool

I have shouted this app out a lot since it came out and I started using it, because I think it’s really the best way to do it right now. If you are in Canada, the UK, Europe, Australia – which I’ve been surprised at, listening to the make-up of my listeners – I don’t think Ready for Zero works with banks outside of the United States, so if that is the case, you can go to bankrate.com where they have some great debt calculators that help you do the same sort of rolling out the plan, seeing how much you want to pay each month and how to pay off that highest interest debt first.

This takes a little more work from you, whereas if you have the app it sucks in all the transactions and interest rates and it also updates your credit relatively frequently so you can see how the actions you’re taking affect your credit every three to six months.

I really love how it shows you the daily interest you’re paying, because for me it made such a difference just to see how much that was every day and realize, wow, when I get all of this debt paid off, that’s money in my pocket every single day. It’s like giving yourself a raise, getting rid of all the interest we pay.

If you enjoyed this episode you can subscribe to Financial Fluency here on iTunes.

Mastering Money Matters

What if managing your money and feeling wealthy was easy?

Imagine going from feeling sick to your stomach every time you have to pay a bill, to having a system that pays all of your bills on time, and shows you at a glance where all of your money is and where it is going.

Mastering Money Matters will show you a new way of looking at your finances so you can set up your systems, enjoy your money, and stop worrying about your next bill.

If you’ve been desperately avoiding looking at your finances and hoping it all just magically works out – money comes in, it doesn’t run out, and you have enough for a bit of extra spending – enroll in Mastering Money Matters today.

Financial Fluency Episode #17: Mastering Debt and Career Goals with Adrienne Dorison

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My guest this week is Adrienne Dorison. Adrienne paid off a huge amount of student debt and managed to leave her corporate job in just SIX MONTHS!

Before you think “I could NEVER do that” take a little time to understand how Adrienne put the pieces together to enable her to be able to achieve this. We also talk triathlon training, marshmallows and taxes!

Debt Doesn’t Have To Be A Way Of Life

What I really love is that Adrienne brings up the idea of not accepting the common belief that you have to spend 24 years paying off your debt, whether that is mortgage debt or student loans.

Sure, it may not be six months but even the difference between 24 years and 10 years is HUGE! So I urge you to listen to Adrienne’s story and get inspired!

Listen in below or Tweet it out here

If you enjoyed this episode you can subscribe to Financial Fluency here on iTunes.

Links we mention:

Dave Ramsey Podcast

Adriene DorisonAdrienne Dorison is the host of The School of Self-Mastery podcast, a no-nonsense business mentor to online entrepreneurs and a passionate dog mom.
She believes success is teachable and can be inevitable for those who are willing to pursue it. It’s something you have to train for. Adrienne teaches her clients & podcast audience about full self-mastery, because making tons of money is pointless if you’re strapped for time, have neglected your relationships (with yourself & others), and haven’t paid attention to your health.
She’s passionate about teaching purposeful entrepreneurs to leverage the crap out of their strengths so they can reach more people and make more profits…while having the freedom to enjoy it all. Some of Adrienne’s personal successes are recently paying off over $45,000 in debt in just 6 months, quitting her corporate job for full-time entrepreneurship, more than doubling her income in her new business and sharing her message with the world through publications such as Business Insider, Art of Charm Podcast, Get Rich Slowly, The Huffington Post, SoMoney Podcast and Clark Howard.

Mastering Money Matters

What if managing your money and feeling wealthy was easy?

Imagine going from feeling sick to your stomach every time you have to pay a bill, to having a system that pays all of your bills on time, and shows you at a glance where all of your money is and where it is going.

Mastering Money Matters will show you a new way of looking at your finances so you can set up your systems, enjoy your money, and stop worrying about your next bill.

If you’ve been desperately avoiding looking at your finances and hoping it all just magically works out – money comes in, it doesn’t run out, and you have enough for a bit of extra spending – enroll in Mastering Money Matters today.

Financial Fluency Episode #14: Investing for Beginners

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Today is about investing for beginners, and I include myself in that, because although I have had investment accounts for my retirement for some time, I still consider myself a beginner when it comes to investing.

You can listen in or read below and Tweet it out here

Here’s how I see it. For the simple fact of interest rates and inflation, unless we’re investing something for the future in some way, we’re really losing our buying power year by year as we go through life. Because of that, I do think that having an amount of money in tax advantaged investment accounts of some kind is really important for everyone’s future.

I’ve never had the kinds of jobs that were attached to 401ks or included employee investment plans, so I didn’t actually start saving for my retirement until I was 30. When I was 30 I put on my list a ‘to do’ that said, “open IRA”. It sat there for most of a year because I just wasn’t sure what to do. I got on the internet, I read a few books, I searched around and I was overwhelmed with analysis paralysis.

I kept thinking,

I need to learn more!

The problem with that is while it is good to learn more and good to get an idea of

  • What you want to invest in
  • What’s important to you and
  • Why you want to do it

there’s also a point where you just need to get started. I’m so happy that nowadays we have some new platforms we can look at to do just that.

The truth is, with losing money over time to inflation and to interest in terms of credit cards and so on, we need to counteract that with getting some gains somewhere. My advice – and I am not a financial planner or a CPA, which means I’m not going to tell you to buy any particular stocks – is to open an IRA.

Your two basic kinds of IRA accounts are the traditional IRA and the Roth IRA. If you go to somewhere like Vanguard – which I do personally like and recommend – you can open either a Roth or a traditional IRA account.

OK, So What’s The Difference?

Short answer? The difference between the two is the way that tax is figured out and also the income cap.

Roth IRA

With a Roth IRA you use after tax dollars, meaning you pay taxes first, but you invest that after tax money and it goes completely tax free, and you can take out as much money as you need on the other end without paying any more taxes on that.

That’s really exciting when you look at the idea that taxes tend to go up rather than down, and also if you look at the idea that nowadays part of lot of people’s retirement plan is to continue to have some kind of ongoing income throughout their life, either through investment properties or ongoing residual income.

A lot of us look into the future and it looks a little grim in terms of being able to retire in the way that we used to think of retirement, and by that I mean sitting on a beach somewhere or golfing or just having enough money to not need any supplemental income in our old age.

Saving the amount of principal that we need to live off for the extended lifespan that we all now have is pretty daunting.

If you think you will have some kind of ongoing income, there will still be some income tax in your old age. If you can offset some of that with a Roth IRA, it’s a great idea.

Traditional IRA

The other kind of IRA is a traditional IRA which means that you save on taxes right now.

You put money in there and it saves you on your tax bill this year which is pretty exciting if you need those tax savings. What it also means is that on the other end you will be paying taxes as you take money out.

You’ll have taxes on your gains and because you put in money pre-tax, you will also have taxes on the money you originally put in. It’s a tax advantaged wrapper, and within that wrapper you can then invest in all kinds of different things.

Income Caps

Another difference between the two different types of IRAs is that Roth IRAs do have income caps both for individuals and couples, so it is worth checking out each year what that cap is. It changes year by year like the amount you can invest and I believe it was around $5500 last year.

We have actually switched to doing a solo 401k for ourselves now because we’re able to contribute both as employer and employee, but again that’s slightly more advanced once you’ve been doing it for a while and you are, like us, trying to make up for some lost time of not contributing when I was younger.

Where To Begin

For beginners, if you’ve done nothing in the past, I totally recommend looking at a low fee index fund which Vanguard has lots of. Other companies do as well, but I tend to recommend Vanguard because it’s very simple, they were the first passively managed index funds that existed, and they’ve continued to do a really good job. They also run the business as a non-profit, which means that they are not paying third party fees.

All of the funds that you buy from Vanguard are Vanguard funds, there are no kickbacks for them selling more expensive products and it’s very straightforward and simple. I like the interface, the website’s easy to understand and you can always call or chat and get information from somebody there.

However, in order to start with somewhere like Vanguard, you do usually need a thousand dollar minimum. It’s great if you can max out your contribution every year which will change slightly year by year.

For self-employed people there are also a few other options like SEPs and solo Roth IRAs that you can look at as well.

For beginners I’m going to move onto these new platforms where you don’t need to have as much as a thousand dollars saved up to get started. Two of my favorites are Betterment and Acorns.

Betterment does allow you still to use this tax advantaged wrapper, so if you want to start an account and have it as an IRA, you can do that with very small amounts of money, such a ten dollar a month recurring transfer from your checking or savings account. The more you put in, the better and the more you’ll get set aside over time, but there is no minimum.

Acorns does not have IRAs at this time, however the Acorns strategy is to round up from your purchases. You hook up the Acorns account to a checking account that you’re already making purchases out of, and if you buy something for two dollars and 50 cents, it will grab that 50 cents leftover, make your purchase three dollars, and that 50 cents is going to go into the account where it can be invested. Cool, right?

Once it’s In, it’s In

With all of these options, these are not things that you want to put money into that you’re going to need in the short term, especially for the retirement accounts, the IRAs. Putting money in there means it’s staying in there. If you pull it out early, there are tax consequences, there are fees, it’s much worse than putting it into a savings account and pulling it back out.

So you need to be serious about your commitment to leaving this money alone, and even in Acorns – which does not have the tax advantages or the tax consequences for pulling it out – there are trading fees involved. This is investing, this is not just savings.

You will get the advantages of investing by having higher returns than a savings account, but it also means that there are some fees involved, particularly if you put money in and pull it out within a year.

There are slightly different tax consequences to different types of trading when it comes to investing. Because so many people do this sort of day trading where they’re really quickly buying and selling different things, that has different tax consequences than the buy and hold. If you buy and hold for more than a year, you’re taxed at a different year than if you buy and sell within the same year.

My Advice

My advice to anyone looking at all of these things is that this is money for your future.

This is you buying yourself some nice things and some security in your old age.

This is something your future self will definitely thank you for! Look into this really seriously. I’m going to leave it at just these first three companies that I talked about because I think that’s a really good start. Take a look at Vanguard, take a look at Betterment and take a look at Acorns and see what you think.

How You Can Get The Minimum Investment More Quickly

If you want some time to save up towards a Vanguard account and are having trouble getting that thousand dollars together, another great option that I want to bring up is Digit. I talked about this before in an episode on savings and I was just looking at my own Digit account again the other day and I am really impressed with how much they have been able to pull out of my accounts without really feeling much pain from it.

I can see the transfers go out, but it’s not been large amounts and it built up pretty quickly. I have about three thousand dollars in there from last summer and it’s worked really well.

If you want to save up enough to get a Vanguard account instead of going with Betterment or Acorns, you can open a Digit account (this is my invite a friend account, so if you use it and open an account we’ll both get a little gift!).

It studies your spending habits, and decides when to pull out these small amounts. It does have an overdraft guarantee, so there’s a little bit of extra added security, plus it can get you to that thousand dollars where you can start really investing more towards the future.

Over To You

I hope that this will encourage you to start saving towards the future, especially if you can do a tax advantaged account. Sometimes people are really surprised by how much they save in taxes by putting away money into their funds. It’s not a one for one, or anything, it’s not like you get ten thousand dollars off your tax bill by putting ten thousand dollars into a tax advantaged savings account, but it might be more like you get 7500 off your tax bill by putting ten or 11 thousand into this savings account.

You don’t have it to spend now, it’s money coming out of what you make this year, but you have it for the future, and you’re going to want that in the future.

I highly recommend that you sit down, take a look at this, think about your retirement accounts and think about what your goals are, how much you want to have. There are some great calculators for this at bankrate.com, and Vanguard has their own calculators as well.

You can put in how much you want to have available to you and see what kind of accumulation you’ll need to get in terms of principal to live off that amount in retirement. You can compare that with social security income, you can pair that with other streams of income if you have any or are planning any, but it’s great to take a look and think about what kind of lifestyle you want in your old age.

None of us want to be very old and very broke, so this is the time to think about it right now. Tweet That!

Thank you so much for listening.

If you enjoyed this episode you can subscribe to Financial Fluency here at iTunes.

Mastering Money Matters

What if managing your money and feeling wealthy was easy?

Imagine going from feeling sick to your stomach every time you have to pay a bill, to having a system that pays all of your bills on time, and shows you at a glance where all of your money is and where it is going.

Mastering Money Matters will show you a new way of looking at your finances so you can set up your systems, enjoy your money, and stop worrying about your next bill.

If you’ve been desperately avoiding looking at your finances and hoping it all just magically works out – money comes in, it doesn’t run out, and you have enough for a bit of extra spending – enroll in Mastering Money Matters today.