The Money Multiplier—and the Money Trap: Understanding Interest and Debt

Compound Interest

Two friends, Alex and Jordan, each put $1,000 into savings with a 10% interest rate compounded. Alex starts at 20 years old, while Jordan starts at 28 years old. Same amount. Same rate. One difference: time. Alex will double his money eight years earlier than Jordan, just because he started earlier. This is compound interest: money that grows faster as time passes, like a ball gaining speed when rolling down a hill. Patience opens the door to wealth creation.

For instance, if we start with $100 and 10% is compounded annually, in the first year the account's balance will be $100 + $10 = $110. The second year it would be $110 + $11 = $121. As illustrated, the interest compounds: you get interest from the interest of previous years. In this scenario, the equation for the account's balance is:

The formula is more than arithmetic; the compound interest formula is a model of exponential growth—illustrating how small, steady savings magnify over time.

Based on this equation, how can we find out how long it takes to double the money? We would have to do the following algebra:

If $100 becomes $121 in two years and doubles in 7.2 years, what will patience deliver in a lifetime? To that end, begin saving early: over decades, as shown by the compound interest formula and the Rule of 72, small returns compound into large savings.

Credit

How can we determine if someone will pay back the money we lend them? We can determine their credibility using their credit score. In 1956, Fair Isaac Corporation took inputs like total debt, payment history, and length of credit history to create the FICO score. The FICO score ranges from 300–850: 750–850 is excellent, 720–750 is good, 650–720 is fair, and anything below 650 is subprime—not creditworthy.

Bureaus, organizations that take the inputs and apply the FICO algorithm, compute the score. Then, FICO converts that data into a credit score. The main bureaus include TransUnion, Experian, and Equifax, where you can inquire about someone's credit score.

Your credit score influences your interest rate and whether the bank will give you a loan. If you have an excellent credit score, you'll get the loan at a low interest rate. If you have a good credit score, you'll get a loan at a higher rate. If you have a subprime credit score, you probably won't get the loan at all. Therefore, it is crucial that you pay your debt on time, as a low credit score increases your interest and may prevent you from receiving loans. Your credit score is your financial reputation—uphold it.

Credit Cards and Loans

High APRs (Annual Percentage Rates) can sneakily inflate your debt. Over years, they can add thousands to your debt if you aren't aware. Credit card interest rates are based on their APR. However, credit cards often apply a daily periodic rate equal to APR ÷ 365 and then compound interest daily. Since the interest is compounded daily, the effective annual rate (EAR) would be higher than the APR. The EAR is calculated as follows:

For instance, if the APR is 22.8%, then the daily interest rate would be 0.06247% daily. In this example, using daily compounding, the equation is:

Completing the calculation for day 365, the effective annual rate would be 1.0006247³⁶⁵ = 1.257 or 25.7% annual interest, which is 2.8% greater than the APR (22.8%). That difference compounds into thousands over years. Compound interest rewards patience; credit card interest punishes it. Therefore, it's crucial you avoid high interest rate credit cards and pay your balances on time.

Paying Off Debt: High Rate vs. Snowball Method

Suppose you have these balances:

High Rate Method

According to the High Rate Method, we should start by paying the loan with the highest rate. Based on our balances, we would first put the extra money into the retail card (30% APR), then the credit card (20% APR), next Loan A (10% APR), and last, Loan B (5% APR). Adhering to the High Rate Method, you would pay off your debt in 47 months and pay $3,900 in interest.

Snowball Method

However, psychologically, what if you want to worry about fewer things by getting debt out of the way? We could use the Snowball Method: pay the smallest debt first. In this case, you would first pay the credit card, second pay off Loan A, third pay off Loan B, and last the retail card. Although it may be psychologically pleasing, the Snowball Method will pay almost double in interest, and it will take seven months longer to pay back the debt in this scenario. Still, by putting down money for debt, you are making progress.

The High Rate Method is mathematically optimal. The Snowball Method, conversely, is psychologically optimal. Both reduce debt—one prioritizes efficiency, the other motivation. Speed: High Rate. Mindset: Snowball.

Personal Bankruptcy

What happens if someone can't pay back their loan? On one hand, the debtor owes the money. On the other, the creditor lent it. The debtor may have to file for bankruptcy. There are two common chapters:

Chapter 7

Let's say you have an overwhelming amount of loans for cars and houses that you can't pay back. You could file a Chapter 7 bankruptcy: a straight bankruptcy, in which the bank takes your assets and splits them among creditors, but afterwards you will be free of debt. Why doesn't everyone do this to clear off debt? First, the bankruptcy will remain on your credit report for 10 years, lowering your credit score. This lower credit score will increase interest rates on loans and prevent loan approvals. Additionally, Chapter 7 bankruptcy doesn't cover student loans or child support.

Chapter 13

The second bankruptcy is Chapter 13; it's like a reorganization. If you have a job, yet you can't pay back your debt, you could file a Chapter 13 bankruptcy. You and the creditors would come up with a plan to pay the debt in 3–5 years. You would often pay a reduced amount with decreased interest. However, it shows up on your credit report for seven years.

Bankruptcy can ameliorate an impossible financial burden by clearing or decreasing your debt, but it affects your credit score and future. Hence, you should only file for bankruptcy as a last resort—not an easy way out.