Compound interest

Explaining Compound Interest to Your Members: Snowballs and the Eighth Wonder of the World


According to legend, Albert Einstein once said, “Compound interest is the eighth wonder of the world. Whoever understands it wins … whoever does not understand it … pays it.

While controversy swirls over whether Einstein actually said or wrote these words, there is no doubt that compound interest is one of the most powerful – and least understood – concepts in the world of science. ‘investment. Why so powerful? Because understanding how compound interest works and using it to your advantage can earn you money. A lot over time. Credit union leaders understand the concept of compound interest, but many members of your CU cannot. Why? I am confused. Maybe because it’s not usually taught in school. Perhaps because the subject of our own money seems to be a semi-taboo topic of discussion in our society. Maybe because it’s not sexy. Either way, it cannot be the result of complexity – understanding compound interest is not exactly the same as understanding the theory of relativity. But fear not. Here’s a simple English primer on compound interest and a way to teach your members how they can leverage it over time to increase their investments, whether it’s in a savings account, 401 (k), SEP. , IRA, university fund or any other investment.

Savings with reinvested interest do not increase in a straight line; he grows exponentially

Many non-financial people believe that savings with reinvested interest grow in a straight line – an arithmetic progression. As credit union leaders know, this is not the case; it develops in an increasingly ascending curve – a geometric progression. Compound interest, in the context of investing, is interest added to the principal, which then itself begins to earn its own interest from that point on. Earn interest on interest. Very interesting. It is the interest payments generated from the principal of an investment account that are added back to the principal so that the past interest also begins to generate interest on its own. Like a snowball rolling down a hill. As the snowball (the main one) rolls, it picks up more snow (the interest), which makes the snowball bigger, which makes the snowball pick up Following snow every time he turns around. Before you know it, you’ve got a big snowball. And you are happy as a child! This analogy is so apt that it was used in the name of a book about Warren Buffett, the greatest investor of our time – perhaps of all time. The book is called The Snowball: Warren Buffett and the Matters of Life. Buffett is a buy and hold investor who generally prefers to buy stocks (often with “float” or premium payments from his holdings with his insurance company) and hold them for a long time while their price is rising. appreciates over time and that dividends (eg, interest) generated by them is fed back into the stock.

Fortunately, your members don’t have to be Warren Buffett to enjoy the snowball effect of compound interest. And they don’t need to study all the great formulas on Wikipedia’s “Compound Interest” page to reap the rewards of this slow, silent financial wonder. Just snowball by contributing to a 401 (k), SEP, IRA, or children’s fund and keep adding to it automatically every two or four weeks with payroll or bank account deductions. Then go down a hill (on a slope that they feel comfortable with and is right for them) by investing in reputable mutual funds, stocks and / or bonds that they understand. They shouldn’t throw it down a steep, rocky, double black diamond trail, unless they know the risks and are willing to live with the possibility of their snowball shattering into a tree or boulder after having grew up quickly and tall. On the other hand, they have to be wary of being too conservative when choosing an extremely conservative Rabbit Hill which can result in a very slow rollover and a small snowball which may not create as much aggravation over the course of the day. time. And regardless of the incline, they should resist the temptation to temporarily stop the snowball from rolling while they extract a piece of it to buy a new luxury car or take a vacation in Europe. While expensive follies are fun, the growth of their poor snowball will be slowed by such interference as its mass and momentum will be impaired. Instead, suggest that they consider setting up a separate ‘fun’ account at CU with the idea that they will invade it without guilt when the spirit of splurging (within reason) moves them. in the future.

The key to investing and reaping the rewards of compound interest is letting it work for investors by giving them plenty of time and opportunities. And (this is the hardest part) of really to know itself; your true tolerance for risk, your financial goals, your overall financial situation in life, and your time horizon so that when your investing snowballs slowly come to a halt, it will be large enough to meet your goals. If members do it right, as the snowball grows, their main contributions will be pale compared to the cumulative effect. Over time, snowball growth may be fueled more by composition than their contributions. Then at the bottom of the hill they can dig, have a big snowball fight and there is still some left to leave a few snowballs for their children and grandchildren.

All because of the eighth wonder of the world.