Understand the Miracle of Compounding Interest by Mary Hunt on Creators.com

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Understand the Miracle of Compounding Interest

Recently, I heard from Mimi K. of Mississippi. She wanted to know of a way to teach her children about the principle of compounding interest. The next day, I heard from another reader expressing her personal embarrassment that she did not know what it means for interest to compound.

Those questions reminded me of a story I learned from a colleague, Alvin Danenberg. His story takes the financial theory of compounding interest and turns it into an easily understood principle:

In 1492, Christopher Columbus decided he was going to save for retirement. He had one penny, and he knew he could earn 6 percent simple interest every year on his money. He put the penny in his left pocket and placed the interest ($0.01 x 6 percent = $0.0006) into his right pocket for safekeeping. He never added anything to his original penny in his left pocket. Yet the interest accumulated year after year in his right pocket.

Chris is a very healthy guy. He lives today in 2010, 518 years later. He finally has decided to retire. He takes his one penny from his left pocket and adds it to the simple interest in his right pocket.

Do you know how much Mr. Columbus has?

Well, the interest in his right pocket added up to only 31 cents (518 years x $0.0006 = $0.3108). Along with his original penny from his left pocket, he has about 32 cents on which to retire. That's not very good planning.

What could Chris have done differently?

Let's assume Chris was more astute about investing because he knew about compounding interest.

Instead of putting the interest in his right pocket, he put it into his left pocket with the original penny. This added his earned interest to the principal. Over the years, he would earn the same 6 percent interest on the original penny plus the accumulated interest in his left pocket.

At the end of year one, he could have had $0.0106 in his left pocket (the original penny plus the 6 percent interest). At the end of year two, he would have had $0.011236 ($0.0106 plus 6 percent interest). At the end of year three, he would have had $0.01191 ($0.011236 plus 6 percent interest). This is called "compounding" interest. It could have continued for Chris until today, 518 years later.

How much would Christopher have accumulated for retirement?

After 518 years of compounding interest at 6 percent, that original penny would have earned Chris $128,362,511,906.97. That $128 billion is a lot of pocket change!

None of us will live that long, but all of us will have more than one penny to invest. Though returns on most savings accounts are far less than 6 percent right now, the principle of compounding interest applies at any rate, and higher rates will return eventually.

Mary Hunt is the founder of www.DebtProofLiving.com and author of 18 books, including her latest, "Can I Pay My Credit Card Bill With a Credit Card?" You can e-mail her at mary@everydaycheapskate.com, or write to Everyday Cheapskate, P.O. Box 2135, Paramount, CA 90723. To find out more about Mary Hunt and read her past columns, please visit the Creators Syndicate Web page at www.creators.com.

Comments

3 Comments | Post Comment

Christopher Columbus switching pennies between pockets for 518 years? That seems a bit convoluted and, frankly, odd. How about something a little more real world and sensible? Say you put $100 into a savings account that earned 6% simple interest every year. After 10 years, you would have $160 ($6/year for 10 years). Put that same $100 into an account that earned 6% interest compounded every year. The first year, you would have $106. Compounding interest means that, for the second year, you earn 6% interest on $106, instead of only your original $100. Six percent of $106 is $6.36. So at the end of the second year, you would have $112.36. Compounding interest means that, for the third year, you earn 6% interest on $112.36, instead of only your original $100. So at the end of the third year, you would have $119.10, and so on. At the end of 10 years of compounding interest, you would have $179.09, as opposed to $160 earned using simple interest. That sounds a little more straightforward to me.

Comment: #1
Posted by: fft5305
Tue Jul 13, 2010 6:54 AM

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Re: fft5305--But the Christopher Columbus example is much more impressive. I don't see having an additional $70.09 after 10 years as compelling as $128 billion. The Christopher Columbus story gets your attention, yours shows how it works for you.

Comment: #2
Posted by: BB
Tue Jul 13, 2010 9:53 AM

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Re: BB
To be clear - one doesn't have an additional $79.09 after 10 years. One has an additional Ј19.09, as the $60.00 would have been earned in the simple interest account.
I agree with both of you, though. The Christopher Columbus example is impressive, but none of us is going to live 518 years! The important thing is to save a good proportion of one's earnings, and to read the small print on the accounts in which one invests, to understand how they work.

Comment: #3
Posted by: Miss Pasko
Tue Jul 27, 2010 3:49 AM

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