A Look at the Law of Compounding Interest and Why You Should Care
“Compounding Interest is the ‘Eighth Wonder of the World’. He who understands it, earns it. He who doesn’t, pays it!”
By Dr. Anwar Y. Dunbar
A Thank You To the Buffalo Criterion
Dr. Anwar Y. Dunbar
I want to start this essay by thanking the Buffalo Criterion for allowing me to share some of my writings with my home city of Buffalo. I started writing online content to build my presence as a writer for the day when I would finish my book project entitled, The Engineers: A Western New York Basketball Story. I am in fact close to publishing part one. Visit my writers blog entitled, Big Words Authors and to The Engineers page to learn about the project if you are curious. Also please leave a comment at the bottom of the page if you visit it.
My Inspirations for this Essay
My initial essays on the now defunct Examiner and my first blogging platform, The Big Words Blog Site involved education. Money falls under that umbrella and it’s a topic I have always been fascinated with. Both my parents were savers and were frugal. I later found that these could be two very bad words in the black community depending on who you’re talking to. I further found later that there were a lot of financial things that I did not know. A lot of other black kids aspiring to better lives than those we came from were also like this. ‘Aspirationals’ is a term used regularly in Dr. Thomas Stanley’s Millionaire Next Door series designating people who aspire to look rich and live a rich lifestyle.
Many black people are cultured and socialized to consume and spend money with little thought of saving and investing it. Corporate America and other ethnic groups know this all too well and capitalize on it. Meanwhile families in other communities talk about investing money and building businesses while we generally discuss things like consumption, entertainment, politics, etc. This piece was in part inspired by a personal story which starts at the University of Michigan where I earned my doctorate. I got to know other people from other walks of life there. It was further inspired by the Rich Dad Poor Dad books and a children’s book a mentor, a conservative black entrepreneur, encouraged me to read (described in this essay). I hope you enjoy this essay.
Time: A Hidden Cost of Higher Education
“Because we’re getting our Ph.D.s and we’re in school for so long, we won’t start making our money until much later,” my lab mate and senior graduate student Damon adamantly said. “When you save and invest your money, it doubles about every 10 years, and we’re missing out on the ‘doubling cycles’! The classmates I attended Colgate University with, who’ve already gotten out and started working, are already seeing their money double!”
To start this off with some humor, coming from the east side of Buffalo, anyone named Damon I’d ever met up to that point was black, but this Damon was of Greek descent. Damon was a very smart, opinionated and short-tempered guy. He was knowledgeable on numerous topics: current events, politics, and economics, and I loved talking with him while in our research lab as I always learned something.
Damon introduced me to one of my current heroes, Dr. Thomas Sowell and let me borrow his copy of Inside American Education, which Dr. Sowell wrote. I didn’t know it, but that day while our Pharmacology experiments ran, Damon gave me my first lesson ever on ‘The Law of Compounding Interest’. I was in my late 20s, and similar to my learning about the ‘Net Worth’ and a ‘Matching Contribution’ concepts, it was late in the game, but still much earlier than many people learned about it. So, let’s talk about the Law of Compounding Interest and why we should all care.
The Law of Compounding Interest
As opposed to trying to piece together an explanation of Compounding Interest myself, I’m going to simply reference the book entitled, How To Turn $100 Into $1,000,000. My mentor challenged me to read what appeared to be a children’s book. While it is written for children, the book contains lots of valuable information that many adults don’t have a handle on – even those in their 40s and beyond. Since reading the book I’ve given copies to my younger cousins and other youngsters in my circle to give them the chances I didn’t have. You should too!
Before discussing the Law of Compounding Interest, I’m going to jump ahead to Chapter 9: Investing, because for the sake of this essay, it needs to be introduced first. According to Chapter 9, investing is defined as, “Putting your money into something that can potentially make you more money.” There are further several investment classes out there: stocks, real estate, and businesses of all kinds.
Principal and Interest
Two important concepts to understand here are ‘Principal’ and ‘Interest’. Financially, Chapter 8 assumes readers understand the meanings of Principal and Interest in the context of getting a ‘Return on Investment’ (ROI), as opposed to the borrowing context where you’re paying someone else interest on a loan. The chapter quickly starts discussing how Interest can steadily build your Principal from year to year.
If for example you have $100 and it’s invested in something at a 5% interest rate after one year, you’ll have earned $5 so your total principal at the start of year two will now be $105. If you keep that $105 principal invested, your new total after year two will be $110.25, and so on. This is just an example, and this is just with the starting principal of $100, but what if you started with a greater principal – let’s say $2,000, and you steadily added more money to it every month for 10-20 years? For retirement purposes the ideal scenario is to be invested for 40 years allowing one to retire well at age 65. Ideally the person should have started investing/compounding at age 25. However, getting started at any age is the key.
The Rule of 72
The second aspect of the Law of Compounding Interest discussed in the book is the ‘Rule of 72’ on page 84. The Rule of 72 is a calculation which allows investors to determine how long it will take for their money to double based upon a given interest rate. To determine this number, you simply divide 72 by the interest rate that you expect to earn over time. The higher the expected rate of return, the less amount of time it takes to reach your goal. For example, if you divide 72 by an interest rate of 10%, it would take 7.2 years for your money to double. If you divide 72 by an interest rate of 2% the time would be 36 years – hence the importance of looking for the most competitive rate of return relative to your personal risk tolerance when looking for investments.
The chapter cites two more examples highlighting the importance of continuing to add to your principal and then the importance of time. The example on page 86 shows the difference in returns when two siblings both start with a $5,000 investment at the same age at an interest rate of 8%. One sibling continues to contribute to her account out to age 50 – that is $1,000 every year and arrives at 50 years of age with $750,000. The other doesn’t contribute anything further and arrives at 50 years of age with a total of $200,000.
The last example on page 87 gives an example of two people who start investing at different times in life. In this example both subjects become millionaires by 70 years of age. The first individual started saving $1,000 per year starting at age 15 and paid in only $55,000 to reach their $1,000,000. The second individual started at 30 years of age and had to put in a total of $140,000 to reach their $1,000,000. The take home lesson here is that because the first person started earlier, it took them less than half the principal of the second person to reach their $1,000,000.
Joining the Workforce at Different Times and Advanced Degrees
My classmate Damon’s words at the start of this essay, underscores these last two points. Our peers who started working immediately after earning their Bachelor’s degrees, were in theory able to start taking advantage of the Law of Compounding Interest earlier, assuming they knew to do so. Working towards our Ph.D. s, we wouldn’t be able to start the process until much later. But there were other professionals from our peer group who were getting even later starts than us due to the nature of their fields and the amounts of debt incurred during their education; the Law and Medical students come to mind.
Both Blue Collar and White Collar Workers can Use the Law
There’s another piece to this though. What about individuals who didn’t go the college route at all? They too would’ve been able to start using the law earlier in life assuming they knew about it and followed it. So, as I’ll describe below, having a degree has nothing to do with using this law.
Who should care about the Law of Compounding Interest? Everyone. That goes for STEM professionals like me and Damon, ‘Blue Collar’ workers swinging hammers and digging ditches, cooks in the kitchen, lawyers in courtrooms, non-degreed individuals, business owners/entrepreneurs – everyone. No matter what your profession is, you only must know about the law, start it, and start it as early as you can.
To start using the law and to use it correctly, one must embrace two principles; the learning of Financial Literacy/Money, and Long-Term Thought/Delayed Gratification. Thus far in my writings I’ve discussed the latter principle sparsely, but it’s key here because to take advantage of the Law of Compounding Interest, the individual must think long-term. This means that they must be disciplined enough to live without a certain percentage of their paychecks every month.
They’ll also forgo or delay some short-term luxuries and indulgences for greater gains later – playing the game of ‘Chess’ in a way. This isn’t something that’s necessarily easy to do. Peer, cultural, societal, and in some instances familial pressures can greatly impact one’s financial decision making, sometimes for the worst.
Real World Applications
What are the real-world applications for this? I’ll cite two articles. The first is by Rodney Brooks of the Washington Post and is entitled, 71 percent of Americans aren’t saving enough for retirement. It discusses reasons why people can’t take advantage of the Law of Compounding Interest and set aside money during their working lives. Another piece is entitled, Club Fed millionaire: Membership 23,000 and growing by Mike Causey which discusses the growing number of federal employees who are retiring as millionaires – most self-made. Note that the majority of the people in the latter piece were self-made millionaires. Nobody gave them anything, and they simply methodically prioritized, saved, and wisely invested their money.
There’s a final context for the law, and that’s giving. When you think about higher education, philanthropists and generous alumni often leave gifts to their schools of choice through endowments. Endowments are invested for returns so that they’re continuously compounding and generating returns used for scholarships and operating expenses. Lastly, consider how the lives of your relatives and your community could be changed by having a continuously growing principal and interest you can use in any fashion you see fit: saving up a down payment on a home, college tuition expenses, seed money for building businesses, supporting political campaigns, etc.
What You Know and Don’t Know
If it sounds like an underlying theme of this essay and others like it is that your financial (and life) success is about what you know and don’t know (outside of your profession), then you’re correct. The opening quote for this piece is from the famous Physicist Albert Einstein and it pretty much sums up the importance of this topic – either you’re getting paid, or you’re paying out. We jokingly refer to this in the black community as being either the ‘Pimp’ or the ‘Ho’.
Compounding Interest is something anyone can take advantage of regardless of: race, creed, color, sex, gender or religion. One just must know about it, and then start living by it. If they don’t know about it, they must be curious enough to find out about it. Most financial literacy programs cover it in some way.
Other Necessary Pieces
There are other necessary pieces such as ‘Budgeting’, another bad word for some people. As I stated in my Net Worth piece, it’s not something that can be worked out with your boss, or even legislated by the government. I do think schools could do a better job of teaching this information at an early age. In closing, two other principles tie in here, and they are Self-Accountability and Self-Reliance, because first, the individual has to realize that no one can make them practice and incorporate this law into their lives. Secondly, it’s themselves who have to do it. And with that, I hope you’ve learned something here about the Law of Compounding Interest.
Closing Thoughts
Thank you for taking the time to read this essay. Thank you again to the Buffalo Criterion for allowing me to share my literary voice with my hometown. Money management is a complex topic which touches all our emotions in some way shape or form. It’s also cultural. As black people there are some things that are baked into our culture. As described, we are socialized to consume and spend as opposed to collectively build, the Ujamaa principle of Kwanzaa. What if saving and investing were adopted by our culture in a meaningful way? What difference would that make? Look out for more of my writings here on the Buffalo Criterion. If you enjoyed this essay and want to reach out to me, you can email me at bwllcnl@gmail.com . You can follow me on Facebook at the Big Words LLC page. You can also follow me on Twitter at @BWArePowerful.