The Power of Compounding Interest
February 7, 2009 1 Comment
“Can I borrow $100?”
This is my favorite question to ask someone when I want to explain the power of compounding interest. I explain to the person that I will pay them back a penny tomorrow, double it the next day to 2 cents and double each day for the next 28 days.
I’ve never had anyone take the deal. Why? Understanding the power of compounding interest is difficult. Unless we are a math whiz, we are unable to comprehend just how much money we would end up with in our pockets at the end of the month.
Just how much would that be? After 30 days you would need a truck to carry your $10,737,418.23 to the bank. Am I serious? How can that be? Here is the math:
| Day 1- | $0.01 | Day 17- | $655.36 | |
| Day 2- | $0.02 | Day 18- | $1,310.72 | |
| Day 3- | $0.04 | Day 19- | $2,621.44 | |
| Day 4- | $0.08 | Day 20- | $5,242.88 | |
| Day 5- | $0.16 | Day 21- | $10,485.76 | |
| Day 6- | $0.32 | Day 22- | $20,971.52 | |
| Day 7- | $0.64 | Day 23- | $41,943.04 | |
| Day 8- | $1.28 | Day 24- | $83,886.08 | |
| Day 9- | $2.56 | Day 25- | $167,772.16 | |
| Day 10- | $5.12 | Day 26- | $335,544.32 | |
| Day 11- | $10.24 | Day 27- | $671,088.64 | |
| Day 12- | $20.48 | Day 28- | $1,342,177.28 | |
| Day 13- | $40.96 | Day 29- | $2,684,354.56 | |
| Day 14- | $81.92 | Day 30- | $5,368,709.12 | |
| Day 15- | $163.84 | |||
| Day 16- | $327.68 | Total- | $10,737,418.23 |
While this may be an extreme example, it serves to prove my point. When you start saving money, at first you won’t see much progress. Over time as your interest compounds, you will be earning more and more money.
If you were to deposit $100 a month at an extremely conservative 2% annual interest rate for 25 years you would have deposited $30,000 but you would have $39, 046.92. Bump that rate to 5% and the same $30,000 would earn you $29, 899.10 for a grand total of 59,899.10, nearly double the amount you deposited!
Isn’t interest grand? Now, just imagine how well off your credit card company is doing charging you 14.99% APR…
About Steven
What I’ve learned from a book I’m reading is that humans have trouble understanding anything that isn’t linear. Compounding interest is exponential when measured from the initial principle. I myself don’t struggle with it, but like you I see many people who do.