In his book, Rich Dad Poor Dad, Robert Kiyosaki writes, “The poor and the middle class work for money. The rich have money work for them.” One of the greatest examples of this is when it comes to interest. The poor and middle class are normally working to pay the interest, while the rich are getting paid by the interest. The greatest thing about interest though is that it does not discriminate. The poor and middle class can harness the power of interest just as the rich.
There are two main types of interest that are dealt with in everyday life. They are simple interest and compound interest. Before we delve into each though, let’s first look at the definition of interest. Webster’s 1828 Dictionary defines interest as, “Premium paid for the use of money; the profit per cent derived from money lent, or property used by another person, or from debts remaining unpaid.” In my own words, interest is a charge paid by someone to borrow money, usually expressed as a percentage. Webster’s goes on to define simple and compound interest as, “Simple interest is that which arises from the principal sum only. Compound interest is that which arises from the principal with the interest added; interest on interest “
In essence, simple interest is interest paid on the principal (amount borrowed or amount owed) only. If you were to take out a simple interest loan for $1,000 with an interest rate of 10% for three years, the total amount you would repay is $1,300. At the end of year one you would owe $1,100, year two $1,200, and year three $1,300. This is because each year the amount owed is calculated off of the principal which is $1,000 and 10% of 1,000 is 100. If you were to pay off $500 of the loan in year 2, then you would repay $1,200 total as year one you would owe $1,100, but in year two you would only owe $650, and then $700 in year three. Common examples of simple interest include debts like home mortgages and car loans, but include wealth creation vehicles like CD’s (not all CD’s are simple interest, some use compounding).
As mentioned above the second type of interest is compound interest. Albert Einstein is purported to have said, “Compound interest is the eight wonder of the world. He who understand it, earns it…He who doesn’t…pays it.” Webster’s 1828 Dictionary defines compound as, “To unite or combine”
If we were to take our example from above of borrowing $1,000 for three years, but change it to a compound interest loan compounding annually, we would end up repaying $1,331 total. At the end of year one we would owe that same $1,100, but in year two we would have to take ten percent of $1,100 giving us 110, bringing the year two total to $1,210, and repeating the process in year three with $1,210 to get the total amount $1,331. If we were to pay off $500 in year two we would get a total repayment of $1,226.
Common examples of compound interest include debts like student loans and unpaid credit card bills, but they also include wealth creation vehicles like savings accounts and investment accounts. While the stock market does not work on compound interest, if you are invested and receiving dividends that you reinvest for a long period of time it greatly mimics the principles of compounding interest.
One thing to note with compound interest is that depending on the wealth creator or wealth inhibitor you have it may compound several times a year. Common examples are quarterly, monthly, and daily. If we were to use the example above but have it compound quarterly you would owe $1,344.89, monthly: $1,348.18, and daily: $1,349.80.
While I am using a relatively small number, $1,000, for ease of examples I hope that you are seeing by the different repayment amounts above that it is very important to know not only what type of interest a wealth inhibitor/creator has, but if it is compounding it is also very important to know how often it compounds. To do the majority of the math in these examples I used an online compound interest calculator.
I personally believe that interest is one of the greatest wealth builders, but also one of the greatest wealth inhibitors. As the current third richest person in the world, Warren Buffet has said, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” This is because Warren Buffet has placed his money in compound interest wealth creators as opposed to compound interest wealth inhibitors (debts). Warren Buffet gets paid by the interest, as opposed to paying the interest.
I would encourage you to take a look at your life and see if you are paying the interest or if the interest is paying you!
