Updated: Jan 4
A big obstacle many people face to feeling confident about their personal finances is the terminology. Maybe at some point you decided to take control of your finances and not long into your research, you came across words that may as well have been in a foreign language. It’s easy to get frustrated by the jargon and want to throw in the towel.
First, know that you are not alone. We didn’t learn about financial wellbeing in school...most of us graduate without basic financial knowledge.
Understanding financial terms is essential to being able to form an opinion and to choose with confidence how you manage your finances and grow wealth. If you want to achieve financial wellbeing, you can’t skip this step.
Unfortunately, the terminology is not intuitive. Fortunately, it’s not rocket science.
The 8th Wonder of the World
At INVESTERA, we believe that everyone is capable of understanding finance lingo and we want to demystify the jargon. Let’s kickoff with a concept that gets thrown around a lot, “compound interest”.
You’ve likely heard references to “compound interest”..but people rarely pause and take the time to explain it. Maybe you kinda know what it is but wouldn’t be confident in explaining it. So, let’s get clear on what it is.
Allegedly, Albert Einstein called compound interest the eighth wonder of the world. “He who understands it, earns it ... he who doesn't ... pays it.”
Simply put, compound interest is when your money makes you more money. You earn interest on your interest.
When you first deposit money (the principal amount) into an interest-bearing account, the interest that accumulates is added to the principal amount, and the next interest calculation is based on both the principal and the interest. Then this happens over and over if you hold your money in the account.
Interest can be compounded on any given frequency schedule, the most common compounding time intervals are:
Annual: once per year
Quarterly: four times per year
Monthly: 12 times per year
Weekly: 52 times per year
Daily: 365 times per year
Therefore, when calculating compound interest, the number of compounding periods makes a difference.
How Compound Interest Works
Here is a basic example for illustrative purposes of how compound interest works.
Let’s say you place $1,000 into an interest bearing account. And let’s say that the first year you earn 10%, or $100. The next year you would start with a balance of $1,100 (the principal plus the interest you earned). In the second year, you also earn 10%. Now you earn $110 on the $1,100, so by the end of the next year you had $1,210….and so on (for ease we’re going with 10% each year)…So after 5 years, you have $1,610 total. You started with $1k and without ever depositing any additional money, you have an additional $610.
Initial Deposit: $1000 (principal amount)
Year 1: 1000 + (1000 x 10%) = $1100
Year 2: 1100 + (1100 x 10%) = $1210
Year 3: 1210 + (1210 x 10%) = $1330
Year 4: 1330 + (1330 x 10%) = $1460
Year 5: 1460 + (1460 x 10%) = $1610
Most of us are familiar with “simple interest” which would be a fixed number. For example, 10% of $1000” or a $100 added each year. With the example above hopefully it’s clear you don’t just get an additional 10% of your initial principal amount each year. Even better, with compound interest you get an additional 10% of your total (the principal amount plus all of the interest that has been previously earned) every year.
If you prefer a video explanation, check this out:
The Power of It: Reach a Million by Retirement
Compound interest allows your money to grow more quickly—and exponentially—over time. Let’s look at a few scenarios that demonstrate how you can build wealth.
Let’s say you start with an initial deposit of $1,000 into an interest bearing account. Then, you add $320 each month to the account. Let's look at the difference between having it in savings versus investing.
Savings: Best case scenario, it is in a high yield savings account earning 1% interest a year (note this type of savings account generally pays 20-25 times the average of a standard savings account, most often it is with an online bank). Over the course of 40 years (average working lifetime) you would save just under $200,000. That’s nice.
Investing: NOW, if you had placed the same amounts into an investment account with an average annual rate of return of 8%, after 40 years you would reach over $1 million dollars at retirement! Over this period of time, you would have contributed roughly $154,600 and would have earned with compounding interest a total of $1,016,502.
And what if you earned a 12% average annual rate of return? Your balance would be over $3 million! That, my friends, is a powerful testament to the exponential growth that occurs when your interest earns you interest over time. You can see why it’s important to begin investing as soon as you can and as much as you can.
This is of course in the scenario where you are earning interest and it’s working FOR you. The reverse scenario is when you are paying compounding interest. For example, on a loan or high interest rate credit card. Paying compound interest sucks. You can imagine with the snowball effect, how it accumulates and could lead to getting stuck in debt. Back to Einstein: “Those that understand interest earn it, while those who don’t pay it.”
So that’s compound interest in a nutshell. As for other financial terms..in my personal learning journey, anytime I've come across a term I didn't fully get, I have looked it up. Why is this important? Financial independence to me also means understanding the information I am consuming so that I can have an opinion, question it if needed, and most importantly, decide how it relates to my situation and choose how I want to act on it in pursuing financial wellbeing.