Debt
The Curse of Compound Interest: Part 2
By Daniel Muniz

How fast can your debt balloon out of control until it blows up in your face?

Millions of people who have filed for bankruptcy or who are teetering on it already know how rapidly one can descend into a black hole of debt. But to add insult to injury, it is not the original contractual obligations that crush the debtor but the compounding interest that plunges the debt to the point of no return.

Below is a table from the article “Wealth - Miracle of Compound Interest: Part 1” which illustrates what happens if you were to invest one penny and have its value doubled every day.
 

WEEK 1
Day 1	Day 2	Day 3	Day 4	Day 5	Day 6	Day 7
0.01	0.02	0.04	0.08	0.16	0.32	0.64

WEEK 2
Day 8	Day 9	Day 10	Day 11	Day 12	Day 13	Day 14
1.28	2.56	5.12	10.24	20.48	40.96	81.92

WEEK 3
Day 15	Day 16	Day 17	Day 18	Day 19	Day 20	Day 21
163.84	327.68	655.36	1,310.72	2,621.44	5,242.88	10,485.76

WEEK 4
Day 22	Day 23	Day 24	Day 25	Day 26	Day 27	Day 28
20,971	41,943	83,886	167,772	335,544	671,088	1,342,177

In each subsequent day, the earning power of that sum is then used to double its value for the next day. As a result, compound interest can turn an investment of one penny into millions of dollars within one month.
 

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And the point of the above exercise is to demonstrate that compound interest can give you fabulous wealth because the earning power of each day’s total can be used to generate bigger returns especially if you view this concept spanning like 30 years instead of 30 days. See “Wealth - Miracle of Compound Interest: Part 1” for more details.

However, as the people who have been crushed by enormous debt already know, the reverse of this process can devastate a person’s finances. Consecutively doubling one penny of debt and allowing it to spiral out of control can have grave consequences because of compound interest.

Instead of reducing the principal of the debt that you owe, interest grows in size. Now you have to pay off a bigger piece of the total which then takes much longer to zero out. That is not really a big deal if it is a one time occurrence but it can become a huge problem if it happens regularly.

For example, let’s say there is a late charge to a credit card and then over the course of a few years, there are more than a dozen late charges. Now suppose the card is maxed out and every payment is for the minimal amount. And finally, suppose whatever remaining available balance from that last payment is spent thus incurring an over-limit charge as well as resulting in a maxed out card. Instead of keeping a low balance with a nominal interest charge, the card is now perpetually maxed out with payments only barely keeping it under the credit limit.

Something similar can happen with installment loans. Lenders love to offer you the option to skip your December payment so that you have extra money for Christmas. The extra interest is then tacked on to the end of the note as well as the principal and interest that you missed. And if you ever get in a bind, financial institutions will give you the option to skip one or two months while tacking what is missing at the end of the note. So it doesn’t take very much to add an extra year or two to an installment loan with plenty of additional interest.

However, the most pernicious trap is car loans, especially when you have negative equity. Car dealers are thrilled to allow you to drive off in a new car even though you still owe more than what your current car is worth. They just roll over the remainder of that note into your new car loan. A few years later, you can still stroll into a different car lot with an even larger negative equity and still drive off in a new car.

Today, it is becoming commonplace for millions of Americans to have never owned a car outright because they keep trading it in before paying it off. In fact, there are plenty of people driving around in cars that have two or three negative equities from previous car notes attached to it. Their auto loan then turns into the never ending car payment. They would have been much better off just leasing a car instead of being a slave to gargantuan interest.

The same concept also applies to student loans. For example, a six month forbearance here and then a few more over the next several years and whatever progress that has been made on the note goes out the window. In the meantime, interest keeps piling up. And then there are the options to make payments as low as possible in which hardly no principal is reduced. All of sudden, a student loan becomes a never ending payment.

But for families deep in debt, it is not the one item that sinks them, it is often the combination of every bad situation like multiple maxed out credit cards, installment loans that become extended for years, the never ending car and student loan payments, and late charges on everything else. The sum of all of the interest and surcharges then reach a critical mass and explode when an income can no longer meet the payments.

Although compound interest can create phenomenal wealth, it can easily become a curse because of how quickly it can accumulate burdensome debt.

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