Written by Therese Faessler.

Financial literacy is an important tool to add more equity and opportunity to a society. In my first article, Why being financially literate is good for you, the economy, the country and society as a whole, the focus was on the impact of a financially literate individual on the household they live in and ultimately our collective society. In a second article I described the core components of the framework of financial literacy. In the second blog I discussed why the order of the quadrants is important. In the third blog the focus was on handling money, saving and budgeting. With saving I mean paying your future self-first. In this fourth blog, the focus is on compound interest and how it affects not only your savings and possibly investments, but also your debt. Exponential growth rates, (compounded interest) happens when the when gain or loss is added onto the initial investment or debt. Therefore, the exponential growth can be positive and negative (more savings or more debt).

The Financial Literacy Core Topics

On the internet when searching for financial literacy, many hits will include investing in “safe” investments like ETFs. But real financial literacy starts way before investing. Financial literacy starts with forgoing consuming something today, to have enough for tomorrow. The core topics are saving & budgeting (as a complete component), managing debt and insurance, and wealth creation (investing). Using these core topics, the process of building and accumulating enough wealth to last a lifetime is step-by-step course of action to live by day in and day out. The goal is to accumulate enough wealth during your working years to last an entire lifetime by adhering and living by the knowledge gained from each of these core themes of financial literacy. 

Practice, Perseverance and Patience – It’s a matter of your behavior!

Handling money is the most important fundamental core topic in financial literacy, and it requires discipline. It is about budgeting so that you spend what is left over after saving and not the other way around. Spending more than you earn is creating debt. Putting anything on your credit card is indeed debt, but it only gets “sticky” when you don’t pay it back in its entirety. That allows for the interest on the owed amount to also be subject to interest. This is the definition of compound interest. According to Forbes Advisor’s the US weekly credit card rates report for the week starting May 15, 2024 the average credit card interest rate is 27.65%.

According to Moneyland, Swiss credit card interest rates are considerably lower ranging from 9.4-14%.

Where and Why Compound Interest Matters

As you can see in the chart above, compound interest rates have a profound impact on both debt and savings or investments. The greater the interest rate the more profound the effect of compound interest.

Savings or Investment

In the chart above, money is being saved in a bank account with a ~3 % interest rate. There, as long as the money remains in the account, the interest is compounded. The power of compounding can be achieved with stocks by reinvesting dividends. It can easily be done manually like this. Only shareholders who own a stock on a certain date (the ex-dividend date) are entitled to the dividend. After the ex-dividend date, the share price typically drops by the amount of the dividend.
To reinvest dividends buy more shares of the company using the dividend at the lower after-ex-dividend share price.

Exponential Growth of Debt with Compound Interest

Compound interest has a substantial effect on debt because it increases the total amount owed much faster than simple interest. It’s not an additive growth, it’s an exponential growth.

1. It accelerates the growth of debt by adding to the principle amount the interest due. When debt is not paid in full, an interest payment is added to the total debt. This total debt then in turn is charged by the interest rate.
2. Compound interest rates have a frequency. An interest can be compounded daily, monthly, quarterly, or annually. This affects the accumulation of debt. The more frequently a debt is compounded the faster the debt will grow.
3. As can be seen in the chart above, over time the debt holder ends up owning significantly more than was originally borrowed. Different types of debt are affected differently by compound interest. For example, credit card debt is often compounded daily.

In summary, compound interest significantly increases the amount owed on debt, especially if payments are not made regularly to reduce the principal. Understanding how compound interest works is crucial for managing debt effectively and minimizing the total amount paid and owed over time.

The Implementation – How to Make the Avoidance of Debt an Inherent Ritual

All debts aren’t the same. The mortgage on a house or condominium is not the same as the negative balance on credit card. There two main types of debt. Personal debt may be secured or unsecured debt. Secured debt requires collateral. Unsecured debt is based your creditworthiness. A credit card debt is, for example, an unsecured debt, and a mortgage is a secured debt.  

Here are the 5 basic rules to avoid debt accumulation:

1. Spend only what is left over after saving.
   Pay your balance on your unsecured debt in full each month. To reach this goal, only spend money that which is left over after saving. A credit card is an instrument to build your credit worthiness and to pay for larger purchases in smaller pieces. A credit card should not used to buy things you can’t afford. Only using your card for purchases you can afford is the first and foremost way to avoid credit card debt.

2. Never carry a debt over into the next billing cycle
   Pay your credit card debt in full and on time. Set up an automatic payment with your bank. This way your credit card debt is debited from your bank account before it’s due every month.

3. Keep a low utilization ratio.
   The goal is to pay your debt in full each month. However, if that is not possible, keep a low utilization ratio. A utilization ratio is the percentage of credit currently in use. If you have a credit card limit of CHF 4’000 and make purchases for CHF 2’000 in purchases on your card, you have a 50 percent utilization ratio. As a rule of thumb, make sure your utilization ratio below 30 percent of your credit card limit.

4. Understand the terms of your credit card contract.
   Understanding your credit card contract can help avoid unexpected fees and keep track of your payments and outstanding debt. Different credit cards will have different interest rates and penalty fees. Before you use your card, read through the agreement to understand when you will be charged a fee, how interest will be applied to your account (how often will the interest on the outstanding debt be charged) and when can the interest rate be increased.
5. Don’t have too many credit accounts.
   Having too many credit cards at once makes it difficult to keep an eye on your total debt. The more credit cards you have the harder it is to keep track of your spending and due dates.

A credit card can help establish solid credit rating. Adhering to these rules will help you avoid excessive credit card debt.

In Summation

1. Incurring debt is not a bad thing.
2. Incurring more debt than you can afford is a bad thing.
3. Compound interest on a savings account or by reinvesting dividends (topic for later) has a positive effect on your savings and investments.
4. Compound interest on a debt has a negative effect on your savings.
5. There are tools and methods for make paying off debt, which make it easier or at least less painful.

 

In Summation

1. If you haven’t started saving regularly and rigorously, don’t worry, you are not alone.
2. If you find it hard to start saving the way you know you should, don’t fret, it’s not easy.
3. There are tools and methods to make saving easier or at least less painful.

Introduction to the next article

In our next article we will concentrate on insurance. How much insurance do you need? What types of insurance are there? What is a fair premium?

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of the Swiss Finance + Technology Association.

Therese Faessler is an active member of the Swiss Finance + Technology Association and serves as Head of Financial Literacy. 

She is a strong, global proponent of Financial Literacy and works as an associate at the Swiss National Bank’s educational program. Her goal is to increase financial literacy in individuals as to trigger the ripples and shrink wealth gaps.

She manages a website, invested.ch, which she uses to teach financial literacy at Swiss high schools.