100 Words On: Why Compound Interest Isn't Everybody's Best Friend

Invest $100 that earns a 6% annual return and you’ll have $106 a year later. The uninitiated might expect to see $112 in their account after two, but they’d actually have $112.36 because interest not only accrued on the original principal of $100, but also on the $6 gained in year-one. Left untouched, that account would balloon to $1842 after 50 years — 18 times the original stake! No wonder Albert Einstein called compound interest “the most powerful force in the universe.”

The bottom line: Unfortunately, compound interest is a double-edged sword. It makes dedicated investors very wealthy … and irresponsible borrowers extremely poor.

Photo Credit: NASA Goddard Space Flight Center

21 comments to 100 Words On: Why Compound Interest Isn’t Everybody’s Best Friend

  • that same principle applies to inflation also, doesn’t it?

  • @The Griper. You are right. ( As I see it ) I was not an economist. I was a cocaine addict who became a Plumber! How I always hear it is when parents think they are expert investors because they paid $6k for their house and today it is worth so much more.
    In 1974 Inflation ( Usually 2-3% recently ) hit 11.03%, then in 1975, 9.2% then 5.75%, 6.5%, 7.62%. 11.22%. 13.58%. 10.35% and 6.16% in 1982. In those nine years a $6K home would have increased to $13K. Hero investor? Nope. Just using inflation in the right way. The dangerous way would have been to someone who owed that same 6K. Ouch! Now imagine that the U.S. Debt in 1977 was $708 Billion. I would have liked to explain how inflation worked more, but I only know it is bad and to use it to my advantage. Just as I don’t need to understand how gravity works to push heavy things down hills.

  • Obviously, saving on compounded interest is not advantageous if you will be putting a small amount on the account. However, if you will set aside $1000 at the same interest rate, that will be $1191 in 3 years. You will be making the money 47 years earlier that you would have made in 50 years. I hope I made any sense. =)

    • Len Penzo

      What am I missing … if I started with $1000 my HP15C says I won’t surpass $1842 until year 11 — but I get what you’re trying to say, Cherleen! :-)

  • Very true, not to mention that most interest is now calculated daily, so your interest charges get bigger every day between payments and you pay a little interest on the interest even over the course of a month.

  • So true! I am happy to be on the beneficial side of the sword…

    By the way, it was lovely meeting you and your wife. She seems so down to earth and fun!

  • You’re exactly right. I’d much rather pay off a 15% credit card than I would invest in the market hoping to earn 6%.

  • Chris

    Yes, but that $1842 in 2062 is only worth $465 in today’s world. Still an increase in overall worth, but definitely not as large. Just used an inflation calculator referenced below to back calculate what $ value = $1842
    in 2062.
    (http://www.halfhill.com/inflation.html)

    • Len Penzo

      Yes, inflation diminishes the returns in terms of purchasing power. But that’s the folly of fiat currencies not backed by a gold standard — and a subject for another post. :-)

      Did that assume an annual 3 percent inflation rate? I suspect the rate will be much higher than that in the coming years.

  • or you can work your whole life and save up $900,000 and then the stock market will crash (like it did in 2008)and you will be left with $200,000! That’s what happens when you let someone else control yoursavings… America wants the “herd” to invest in the stock market…or should I say the extremely rich, the ones who influence the media, want the average joe to invest in the stock market and keep promising compounded interest…until they mess it all up…again.

    • Len Penzo

      I hear ya, Jimmy. The average Joe needs to realize it’s our responsibility to read the news and stay aware of what’s going on because nobody cares more about our personal nest eggs more than us. The good news is, we can protect ourselves without the aid of others!

      In fact, by staying aware of what was going on around me in the financial world (by simply reading the news everyday) I was able to avoid losses in the crash of 2008 by pulling all my 401(k) money out of stocks and put it into a stable value fund about 10 months before it happened. All the warning signs were there. The key is stay aware of what’s going on around you.

  • People in debt need to realize this kills them! You normally only hear about the good side though which stinks for those in debt.

  • Oscar

    Of course, when interest rates are at record lows (practically zero) for such a long time….like the last 3 years….compound interest is nobody’s friend.

    • Len Penzo

      I agree, Oscar. The Feds have been holding interest rates down at ridiculous levels for far too long now and, as a result, savers have been getting screwed for years — in fact, we’re all losing money on the money in our savings accounts after accounting for inflation.

      For now, the only way to have a chance at earning 6 percent returns is to invest it.

  • mc

    I’d bet at least a few years of compound interest that Einstein never said or wrote anything about compound interest, or anything regarding finances for that matter, whatsoever. It’s just one of those things that someone probably just made up in the 80s and now it is a commonplace.

    Your Friendly Stickler for Quote Sourcing of the day,
    mc

  • I don’t think I have more than a few hundred dollars in a conventional savings account where you could earn compound interest.

  • [...] 8) Why Compound Interest Isn’t Everybody’s Best Friend [...]

  • [...] Why Compound Interest Isn’t Everybody’s Best Friend – A nice little blurb by Len Penzo on why compound interest is the enemy of the irresponsible. In short, it makes investors rich and borrowers poor. [...]

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