by Eddie Barnett, business manager
When I was in high school, I had a mathematics class that required some research. In my search, I came across a book entitled, Math. Can Be Fun, by Louis Grant Brandes, published in 1956 (math is math, whether it is 2018 or 1956). At any rate, there were a couple of mind binders in the book that really became implanted in my brain, and if I were to admit it, was probably the primary reason that I majored in mathematics when I eventually went to college.
The first describes the difference between "simple interest" and "compound interest" - at the time I would have said "interest is interest". Well not so fast...here is the first story in the chapter labeled, and "You Won't Believe It!"... well maybe you will - eventually.
Are you aware of the difference in return of money invested at simple interest and at compound interest? A single cent, if deposited in a bank upon the birth of Christ, at 4% interest compounded annually, would have amounted to $1.6 x 1033 by 1950. Expressed as a whole number this amount would be$1,600,000,000,000,000,000,000,000,000,000,000.00 (WOW, that is a lot of zeros!) If the same amount had been deposited at 4% simple interest, it would have increased in value considerably less; to approximately $0.79. (Unbelieveable!)
If you think that is a lot, what if it were calculated to year 2018! Well the numbers are so incredible that it does seem a little hard to grasp the impact.
The Lucky Penny
Unlike the last story, this one is a little more understandable because it is for a very realistic time frame - 1 month. It demonstrates "compounding" rather than "compound interest", but the concept is exactly that of compound interest.
A man, broke and on the verge of despair, looked down at his feet one day and saw there a worn old penny. "Maybe this will be my lucky coin.", he thought, as he dropped it into an empty pocket. The next day he decided to gamble (NOTE: I do not recommend gambling as a method of expecting financial growth, but it is referenced in this story) his only penny in a game of chance. As luck would have it, he won. Having gained confidence in the lucky coin, he continued to invest his total finances once each day. Each day he doubled his money. Thirty days after he found the penny, he announced that he was ready to retire; for his single penny had become a fortune. A fortune of $5,368,709.12 in a single month.
What I did when I first discovered this story, I have done a number of times since - manually calculate that doubling process and unbelievably it has come out to that amount every time!
What is Compunding?
These stories are based on a little understood fact of mathematics - compounding. What is "compounding"? Simply put, it is interest earning interest.
Why is it so powerful?
Because as the interest that is earned by the initial capital also earns interest, the value of the account grows at a geometric (ever-increasing) rate, rather than an arithmetic (straight-line) rate. The higher the rate of return, the steeper the curve. You should recognize that "time" is the key to the success of compounding.
Another eye opening example of compounding is found in a website focused on teaching young people the importance of savings.
The exercise is that two 19 year students begin a savings program. The first saver saves $2000 per year for eight years and invests nothing further. The second saver did not start saving until after those eight years and then started investing $2000 per year, every year until age 65. All earnings were based on 10% interest rate. The first saver invested a total of $16,000, whereas the second saver invested a total of $78,000. The second saver netted $805,185 - not to bad, until you find out that the first saver netted $1,035,161 ...that is the power of Compounding!
The success of Compounding is based on one major factor - Time!.
Compounding & Used Cars
ALL IN DUE TIME!..and in our "now" generation of fast food and express checkout, we view "time" as our enemy rather than a friend. Next to our homes, cars are the next major expense. Buying a used car is not going to immediately make you rich. This is not a one time operation as much as it is a long term plan. Be deligent and do your homework and then when you are shopping for that next car, consider a new-used car. There can be great value found in used cars today and the "savings", or that money not spent, can be the source of funding for a whole new financial plan with great rewards to be expected... if we will just give it time.