Compounding The Problem

Albert Einstein hailed the power of compounding interest. But that power works both ways, as payday lenders well know.

 
 

When folks talk about human intelligence, quite often the first name mentioned is Albert Einstein, the original "Master of the Universe," the theory of relativity — E=mc2 — and all that.

Some might not know that Einstein was also financially shrewd and astute, famously noting that "the eighth wonder of the world is the power of compound interest." It does seem somewhat miraculous how quickly compound interest can increase a pool of savings.

A great rule of thumb for estimating growth related to the compounding power of interest is called "The Rule of 72." If you know the interest rate on an investment, then divide it into 72. The answer will tell you approximately how many years it will take to double your money at that interest rate. Here's an example: An investment earning 12% will double in value in six years (72/12 = 6). Equally, an investment earning 9% would be worth twice as much in eight years (72/9 = 8). Got it?

But perhaps a better example of the power of compound interest is to look at the growth in dollar terms. If that long-lost, rich uncle had invested $10,000 at a 12% return — quite possible in a well-selected growth stock portfolio — for you when you were 10 years old, how much money would you have accumulated when you were ready to retire? Go ahead, take a guess!

Well, let's see how it adds up. It's going to double in value every six years (72/12 = 6). So, at age sweet 16, the value has doubled to $20,000. At age 22, it has doubled again to $40,000. Fast forward: age 28 = $80,000; age 34 = $160,000: age 40 = $320,000; age 46 = $640,000; age 52 = $1,280,000; age 58 = $2,560,000; age 64 = $5,120,000. Even at 8% or 9%, you would be sitting on a cool million dollars or so. Would make for a nice retirement, right?

But according to Einstein, everything is relative. So, if compounding "upward" on savings is "the eighth wonder of the world" for wealth building, then what should we call the "downward" compounding on payday loans and overdraft protection plans with truth-in-lending validated interest rates of 400% to 800%?  

Let's see? Using the Rule of 72, how long does it take to cut your wealth in half? (72/400 = 0.18) To be fair, let's round up to one year. Now using our "$10,000 at age 10," rich uncle example, at age 11 you would have $5,000. Again, fast forward: age 12 = $2,500; age 13 = $1,250; age 14 = $625; age 15 = $ 312; and at sweet 16 you can't even afford to go to the prom.

It doesn't take a genius to figure out that payday loans are financial weapons of mass destruction.

Aren't we glad credit unions look after their members?

Jim Blaine is president/CEO of State Employees’ Credit Union in North Carolina. This column is from his blog, “Jim Blaine On Credit Unions.”

 
 

Feb. 12, 2015


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