EBONY HAZELEGER: Start smart: Saving and spending wisely

Editor’s Note: This column, written by Albany consultant Ebony Hazeleger, the owner and creator of Home Plan Advisors, will appear in the Herald twice a month.

Compound interest: how to make it work to your advantage

Compound interest is a powerful tool in the financial world. It affects everything from loans to credit cards to savings. So what is compound interest? Where does it matter the most? And how can compound interest be advantageous to your savings?

To start and to make sure that everyone understands, compound interest is when you earn more interest today on the interest that you earned yesterday. When interest rates increase, you earn more money on your savings and pay higher interest rates on the amount that you borrow. When interest rates decrease, you earn less money on your savings, but it costs less on the amount of money that you borrow and from the use of credit cards.

Do credit cards utilize compound interest?

Many credit cards these days compound interest on a daily basis, not monthly. For example, if you have a revolving balance of $1,000 on your credit card, and your daily interest rate is 0.041 percent, that is equivalent to an APR of 15 percent. If you now multiply $1,000 by 0.00041 and you get $0.41, you would end up paying $0.41 in interest on the first day. As we move on to the second day, your balance would be $1,000.41, and you would pay interest on that total. Moving forward, your interest would keep compounding until your debt is off. This is definitely unpleasant to think about.

If you’re like most people, you want to have the lowest interest rate possible against loans and credit cards. Credit cards possess the highest interest rates because they are grouped within the revolving credit category and are not backed up by a valuable collateral such as a home. At times, you may become stressful thinking about how to pay off that credit card debt. Plus, you might think that it’s impossible to save any money to pay off your debt. But let’s look at it in an encouraging way. Let’s say we took that same credit card balance of $1,000 with 15 percent APR, and with a minimum monthly charge of $50. If you were to add $55.53 to your minimum payment (total of $105.53), you can pay off the loan in 23 months. If you were to pay off your debt immediately, you could avoid the extra debt payment of $1,071.

Where compound interest matters

One of the most important concerns in managing your savings is how much to save. If you’re in your 30s and earn one income, then a question of how long your retirement vehicle will last may place you in a worrisome position. If you spend too much after the age of 65 and live longer than expected, you could possibly run out of money and cheat yourself out of the best quality that retirement life can offer. And let’s not forget inflation.

Let’s say that you had $500,000 in savings. If the average cost of the goods that you buy rises by 4 percent per year, then the purchasing power of your savings falls by that same 4 percent per year.

So where should compound interest matter? Well, by putting your money into an interest savings vehicle, your principal can compound year after year, interest upon interest. This ability to keep every dollar invested can be a big advantage over taxable investments. In fact, having a savings vehicle complements other retirement plans like your 401(k), IRA, Social Security, or any other types of investments.

The effect of compound interest depends on the frequency. For example, if you deposit an initial principal of $10,000 and earn 10 percent interest on the principal for one year, your $10,000 would have earned $1,000 in interest. If you leave that $1,000 in the account for the second year, it will earn $1,100, making your interest earned $2,100. Again, that’s how you earn interest upon interest. It’s as simple as that.

Most of us do not have large sums of money to invest wisely. So how can a family that has a difficult time making ends meet take advantage of compound interest in a savings vehicle? How about downsizing your living arrangements or cutting back your five-day, $7 Starbucks latte that can cost you up to approximately $35 a week to about maybe three lattes a week. You have now made room to save approximately $14 a week. Let’s say for example that you put away $21 a week each month ($35-$14). That’s a savings of $84 a month. Now, if you were to earn 5 percent interest compounded monthly and continue to do that for 10 years, what will you save? Well, you would have earned a future value of $3,309.10 with $768.10 of total interest earned.

Maybe you could do a little better. How about saving an extra $5 per week to add to that monthly credit card payment? Another option could be dropping your cable provider and going for a streaming player like Roku, which allows you to subscribe to different providers like Netflix, Hulu or Amazon Prime.

The longer your money compounds, the more you will amplify your savings. It may seem like a punishment in the beginning when conserving your dollars, but the future rewards will be greater than the sacrifice.

Ebony Hazeleger is the owner and creator of Home Plan Advisors, which specializes in helping families become debt-free, maximize savings for college expenses and retirement, establishing an emergency fund, while minimizing risk and income taxes based upon her smart money management system.” For information, call (866) 248-1871 or visit www.homeplanadvisors.com.