25 November 2010

It's Not the Principle of the Matter, It's the Interest That Counts

If there's one thing I remember from college, it's the power of compounded interest.  One class in particular was all about different software that Industrial Engineers would be expected to know.  Our professor took advantage of the speadsheet lessons to teach some valuable life-lessons, such as: the advantage of making one extra mortgage payment a year, starting to save for retirement one year early, or even putting 1% more in a 401K savings plan every year.  When it comes to compounding, over the long term, even unnoticeable amounts of pocket-change count.

It's hard to resist the urge to spoil two little girls with a pile of Christmas gifts, but long term, is that really a good investment?  Before I get tempted to head out for some early morning Black Friday shopping, I thought I'd do a review on the power of compounded interest.  A quick Swagbucks search reveals that  the average American family spends $935 on Christmas gifts each year (That's according to The American Consumer Credit Council.  I found it on Ask.com, and since the accuracy of the amount isn't really necessary to make my point, I went with it.)  If I were to put that much on a credit card this month, I wonder, what effect would it have on my wallet?  Curious...

Let's say the credit card has an interest rate of 18.9% (I don't actually know what mine is since we never carry a balance, but this is a pretty standard rate - and, I'd understand if you decide to stop reading my financial musings at this point since I don't even know my credit card rate... anywhoooo); if the minimum payment is 4% of the principal plus the interest, by the time it's paid off, in September 2015, the actual cost of Christmas 2010 will be just over $1400.  Those Black Friday deals could end up costing me a pretty penny if I take my time paying them off.   

BUT... just like a coin, compounded interest has a two sides, and if time is on your hands, the pretty face is on the flip side.   Tiny & the Tot haven't assimilated fully to the American Dream yet, so if they each have a few inexpensive surprises to open on Christmas morning, they'll squeal ecstatically.  What if we were to forgo the big spend this year and instead get them token gifts plus put $10 in each of their savings accounts.  Rather than pay interest to Mastercard all year, we'll pay $10 a month to each of their accounts.  If we could keep that up for 18 years, at a modest savings rate of 3%, this Christmas gift will be almost $3000 when they go to college.  To make it more "interesting," I might give them $10 in quarters and let them put it in their piggy banks.  For a one-year-old and a three-year-old, that could be an hour of fun!

As they get older, it'll be harder to convince them that they aren't being cheated, and we'll probably increase the amount we spend on gifts.  Hopefully though, we'll also have opportunities to teach them about budgeting spending, saving, and the power of compounding.  Learning these basic principles won't be fun, but in the end, it'll always work out for their best interest.  ~ It's Plain & Simple As That

Some Tools to help your decision making:
Here's a calculator where you can plug in the amount you plan to put on your credit card, your interest rate, and the percentage of your principle balnce you plan to pay off each month.  It will tell you what your monthly payment will be and how long it'll take you to pay it off.  

Here's a simple savings calculator to see how much your money will grow.  You decide the amount, how much (if any) you will contribute monthly, the interest rate, and the number of years you want to save.   

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