As some of you already know, I’ve been taking classes through Penn State’s World Campus to lead me (hopefully) to become a Certified Financial Planner. My goal is two-fold. First, I think this education will help me to better help my student population. Second, I think this will lead me to a nice side-gig that I can pursue for a bit of extra income after I retire from Penn State. This semester I’m taking a class in Corporate Finance. At first I had my doubts about how practical this class would be for me. But it turns out I really enjoy it.
Last week we started learning about something I’ve been preaching about for years: the time value of money. A dollar today has a different value than that same dollar a year from now. If you put in into a savings account with a 2.0% interest rate that dollar is worth $1.02 in a year. If that dollar was borrowed from a Grad PLUS Loan with a 7.6% interest rate, the use of the dollar is costing you an additional $0.076 for the privilege of using it for the year. Whether you are saving or borrowing (I know…borrowing is much more likely at this stage in your life) it is important to understand the power of compounding interest.
There is a reason you’ll always hear someone telling you to start saving for retirement at the very beginning of your career. The earlier you start, the longer your money has to grow. The older the dollar, the more time it has to age. That dollar that was worth $1.02 after one year is worth $1.48 after 20 years—and that’s at 2% interest. With a more typical 10% retirement investment return that dollar is worth $6.73 after 20 years. $17.45 after 30 years. $45.26(!) after 40 years. The longer the money has to grow, the more exponentially it is able to grow.
Much like you want your interest to compound for as long as possible when you are saving, you want it to compound for as short a time possible when you are borrowing. Because student loan numbers can be scary, let’s look at a car loan. Let’s assume you are borrowing $15,000 to buy a used car. Your interest rate is 4%, regardless of the repayment term. If you take 7 years to pay it off you will pay $205.03 per month and you’ll pay a total of $2,223 in interest. If you shorten that to 6 years, you will pay $234.68 per month and you’ll pay a total of $1,897 in interest. Shorten it to 5 years, and the payment is $276.25 and the total interest is only $1,575. The shorter the term, the less interest you pay. The same rules apply to your student loans and someday your home mortgage. The shorter the time you take to repay it, the less you will pay in interest.
Next time you make a deposit to your savings account or borrow a little extra loan money, take a moment to think about the time value of money. Every dollar is worth more (or less) than you think!