- Compound interest, computational skills and amortization are the three key money concepts we all need to master.
- As Einstein observed, compound interest is a saver/investor’s greatest friend and a debtor’s greatest enemy.
- Creating a budget and sticking to it are essential to building wealth and a secure financial future. Budgeting just takes discipline and the basic math skills that you learned in middle school.
- When paying off a long-term loan, pay attention to the principal versus the interest, not just your monthly payment amount.
Albert Einstein once called compound interest the “Eighth Wonder of the World” and quipped that “He who understands it, earns it. He who does not, pays it.” Compound interest, along with having computational skills and understanding amortization are the three key money concepts we all need to master.
1. Compound interest. Suppose you have $10,000 set aside for retirement. Let’s say you’re deciding between a bond-oriented and a stock-oriented portfolio over 25 years. If the bond portfolio earns 5 percent per year and the stock portfolio earns 8 percent per year—i.e., 3 percent more—what is the difference after 25 years? Guess what? It’s nearly double: $34,000 for the bonds versus $68,000 for the stocks!
2. Computational skills. By the time you were in sixth grade, you learned how to add, subtract, multiply, divide, make estimates, and work with decimals and fractions. Where does this come into play? Budgets. Yeah, budgets! Cash coming in versus money going out. You have to use all of those skills. They are very important. Unfortunately, most people avoid creating budgets because they think budgeting is really hard when it’s really just about using basic math skills we all learned in middle school. But budgets, which include auto loans and home loans, are an essential part of managing your everyday life.
3. Amortization. This relates to paying down debt with a fixed repayment schedule—typically monthly—over a period of time. Let’s take the common 6-year auto loan and the 30-year home loan as examples. In the early years, you pay primarily interest and very little principal. It’s not until the later years of each loan term that you’re paying more principal than interest. That makes a huge difference when it comes to your budget, and it’s one of the most common areas of personal financial mistakes. Cars and homes are expensive emotional purchases. We often try to rationalize them even if our budget suggests we shouldn’t. And that’s where people get into trouble. These are big-ticket items which make a huge impact on our budgets so you really need to understand the concept of amortization before you pull the trigger.
You can find free helpful resources about all three key money concepts online, but you’ve got to do the work.
Until next time, enjoy. Gary