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



Comments

  1. 3

    says

    @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.

  2. 4

    says

    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. =)

    • 5

      Len Penzo says

      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! :-)

  3. 6

    says

    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.

    • 8

      Len Penzo says

      It was a pleasure meeting you too, Amanda! Yeah, the Honeybee is extremely fun; she’s a real people person. (Lucky for me.) :-)

    • 11

      Len Penzo says

      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.

  4. 12

    says

    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.

    • 13

      Len Penzo says

      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.

  5. 15

    Oscar says

    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.

    • 16

      Len Penzo says

      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.

  6. 17

    mc says

    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

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>