Get Sorted: May this force be with you

Happy Star Wars Day! The power of compound interest is undeniable, but it certainly has its dark side.

Trained Jedis of the money world will readily recognise the financial force when they see it: it's the power of compounding. For any young Padawans reading this (or for those you've got in training), I'm referring to the way that interest compounds upwards over time, when the interest you earn earns even more interest, happily as a snowball on Hoth.

But it certainly has its dark side.

First, the light: when you're saving and investing, compounding is the force that grows money. As a simple example, let's compound $1,000 at 10% interest. After a year, you have $1,100. Then that $100 of interest attracts interest into its orbit as well, and by year two you'd have $1,210. Year 10 would be $2,590, and by year 20, it would look like $6,730. See for yourself here with Sorted's savings calculator.

Now back here on everyday Earth you'd have setup fees, tax and inflation to take into account too, so real results would vary, as they say. But compounding is a true force to be reckoned with, especially when you are regularly contributing to your savings or investment accounts.

That's how it looks for the forces of light earning interest. But as I mentioned there is the dark side of compounding, or perhaps I should say the "debt side" of the equation. When we take on debt, we are charged interest instead of earning it, and that interest can compound against us.

"If once you start down the dark path, forever will it dominate your destiny, consume you it will," says Yoda.

Have a look at the Sorted debt calculator or mortgage calculator - you can quickly see that the longer it takes us to pay off debt, the more it ends up costing us. And because of compounding, this can take far longer than we ever thought it would.

And if we get into trouble and miss payments or even default on a loan, the Empire strikes back with penalties and default interest costs that can be devastating. Our finances and credit score can implode like those planet-sized weapons always do by the movie's end.

So whose side are we on? Which side of the compounding equation will we take?

Admittedly, most of us will use debt to get to where we need to go in life, but we can still keep that force of compounding working for us as much as possible, rather than against us. By adjusting our repayments above the minimum amount, we control how much interest we'll pay. Or, as Yoda might say, "Debt is a natural part of life. Rejoice for those around you who transform it into savings."

Warren Buffett, the real-life Obi-Wan of the investing world, said it best when he addressed an auditorium full of uni students.

"Avoid credit cards. Just forget about them... You can't make progress in your financial life going around borrowing money at 18 or 20%. You can make a lot of money by lending it out at 18 or 20% over time, if you can find anybody that's good that will borrow from you. But you don't want to be on the side of the equation that's always behind in life...

"On the other hand, if you get ahead of the game, even on a very modest scale, so that money is coming in from investing... you'll be way ahead of the game compared to always being paying your creditors every month.

"My advice to you is: if you can't pay for it, don't buy it. Get yourself in a position where you can pay for anything."

Obi-Wan would be proud.

Get Sorted is written by Sorted's resident blogger, Tom Hartmann. Check out the guides and tools from Sorted – brought to you by the Commission for Financial Capability – at sorted.org.nz.