Myths of Personal Finance: You Know That Compound Interest is Overrated, Right?

You know, I can hardly look through the personal finance articles of the day without reading something that extols the power and beauty of compound interest.

Personal finance geeks will tell you to start saving as early as you can so you don’t miss out on compound interest. They’d tell you that saving small amounts regularly and not withdrawing your money will make you, eventually, a millionaire. They’d tell you that compound interest is a wonder.

Call me contrary but I’m not convinced. Never have been and never will be.

Why, you may wonder, the attractions of compound interest leave me cold?

It is simple: for compound interest to generate monetary results that are not entirely negligible you either need a very long time or very large amounts of money.

I’ll explain this further and will add some other reasons why I believe that compound interest is overrated. I’d illustrate my arguments with examples and different scenarios (where necessary and possible).

Before I get down to business, I feel it necessary to remind you of a quote by Albert Einstein that is often used to support the claims of the compound interest supporters.

This goes like this:

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein

This quote is often taken to mean that even a genius like Albert Einstein bowed to the power of compound interest and the wonder of making money, and a lot of it, this way.

Have you ever read any of the biographies of Albert Einstein, my friend?

Because I have. And what I’ve learned is that Albert Einstein had very rudimentary understanding of, and virtually no interest, in money. His preoccupation was with the workings of the universe. (Biographers mention that Einstein’s wife negotiated his university salary.)

Knowing that, I suspect that his statement has a meaning broader than money. You see, in the universe things don’t just appear and/or disappear. Einstein’s famous formula is about the equivalence of matter and energy. Seen through the eyes of a physicist, compound interest is a wonder: you get something for nothing because more money appears without you putting more labour or capital in.

I’d urge you to interpret Einstein’s quote with caution because I believe it is rather ‘tongue in cheek’. And he found the equivalence in that some earn it and some pay it…

This out of the way, let me tell you why I believe that compound interest is overrated.

#1. Decent outcome of compound interest needs very long time

Here I simply have to mention another case of which the proponents of compound interest make a very big deal.

Have you heard about Ben Franklin’s experiment?

Okay; here it is.

In his will Benjamin Franklin, who died in 1790, left $4,400 each to the cities of Boston and Philadelphia. There was a condition that this money is used to offer loans to young apprentices that had proven worthy of a loan. His will also stipulated that the cities would have access to some of the funds after 100 years and receive the rest after 200 years.

Now the part about which the compound interest geeks get really excited: when the cities received their balances after 200 years, the combined bequest had grown to $6.5 million!

Can you see anything wrong with this?

Let me help you. This money took 200 years to compound to this staggering amount. Correct me if I’m wrong but there are no vampires amongst you. So, you don’t have 200 year.

Also, once we take inflation into account the number stops being that impressive.

#2. Decent compounding needs high interest rate

There are different ways to shorten the time that note-worthy compounding takes.

One of these is to find high(er) interest rates.

For instance, were you to put your money into an account that compounds at 10% per year, your money will double in 7 years.

Regretfully, what we consider a ‘decent’ interest rate is more like 2% per year. At this rate you can expect your money to double in approximately 35 years.

Which brings us back to the small matter of the span of human life.

#3. Decent compounding needs a lot of cash

Another way to maximise the results of compound interest would be to start with a lot of cash to begin with.

For example, if you have £20,000 compounding at 2% annual interest rate, in 10 years you will have the princely sum of £24,424. In other words, you made £4,424 in ten years which is probably less than the amount your money inflated by.

On the other hand, if you start with £200,000 at the same annual interest rate, in ten years you will have £244,240. This is compound interest of £44,240 which looks a bit more respectable (though the inflation concerns hold).

#4. Compound interest is often over-estimated

This is about something that we’ve already gleaned.

Having your savings/investments make 10% annual interest and double every 7 years sound sexy, doesn’t it?

It sounds great but you may be very unpleasantly surprised when you do your accounting in 7 years and discover that your money hasn’t doubled.

Why?

Because when you started out so full of hope 7 years ago, you forgot to deduce inflation and taxes from your calculation. Which more than halves the level of compounding.

(Please note that the tax systems work very differently in the UK and the US. In the UK we pay marginal tax on earned interest above £5,000 except in the case of ISAs where the interest earned is not taxed.)

#5. Sh*t happens

This one is straight forward, really.

Because earning notable compound interest takes a long time, life can – and indeed it does – get in the way.

And it is not only personal life that can get in the way. We know that banks can fail, the economy can collapse and cataclysmic historical events do occur. Think about what would have happened to an equivalent of Ben Franklin’s endowment made in Russia in 1790, for example? Remember this thing knows as the Bolshevik Revolution of 1917? Yep. It would have messed up the whole compound interest thing big time.

#6. Your money is locked in

Yep; this is correct.

To take advantage of compound interest, such as it is, you have to keep your money in the compounding account.

What if better opportunities come about?

#7. Compounding is speculative

This one is a particular pet objection of mine. You see, compound interest is ‘interest on interest’. It is money born from speculation, not from adding value to people’s lives and the economy. (Remember that value is added by labour?)

‘Money for nothing’ concerns me; it, I believe, increases the imbalance between money and value in our economies and ends in a cataclysm like a financial crash or economic downturn.

#8. Banks are the winners of compounding

Ask yourself why banks offer you interest on your savings?

Yes, this is it. Bank offer you interest because in effect they are borrowing your money to use as they please. They use it mostly to land to other (for much higher interest than they give you) and to speculate big time (according to some, banks are involved in high frequency trading big time).

#9. Investing in yourself probably compounds better

This may be a bit of a controversial statement but…

If you are in your 20s and people tell you to start saving/investing so that you don’t lose on compound interest I’d urge you to think very carefully.

Because investing small sums over a long time is less effective in terms of compounding than investing large sums over a much shorter time span.

Let’s do some numbers here.

Case 1: Joe is in his early 20s and he is saving £300 per month in an account that brings 4% annual interest. Joe doesn’t have much spare cash but what he has goes in savings. He gets married, has family and continues to save £300 per month – he cannot afford any more. He does this for 40 years.  In his early 60s this has compounded to the tidy sum of £355,770.

Case 2: Joanne is also in her early 20s. She has a bit of money put on the side for the do-dads of life (unexpected things you have to pay) but all her spare cash goes on developing herself. She enrols in professional courses and develops competencies that get her higher paid positions. She get married, has family and her money goes on life – housing, opportunities for the kids etc. When she is 45 her expenses drop and her salary is still going up. She can put aside £2,000 per month. She stashes it in an account that brings 4% annual interest for 15 years. When Joanne is 60 she has £493,821 in her account.

Who is better off?

I’d say Joanne; and it is because she cleverly invested in herself.

(If you think that Joanne’s case is hypothetical, think again. Joanne is very much me and how my life has panned out. And I still invest in myself a lot.)

Finally…

It had to be said and I had to say it.

Compound interest is very much a myth of personal finance today.

You have to make sure that your monthly cash flow is positive; and increasingly so.

You have to have some money put on the side when you are still young.

But please don’t fall for ‘oh, if you are not saving aggressively in your 20s you are missing the gravy train of compound interest’ message.

And whatever you do, don’t fall for ‘oh, you are in your 40s so you’ve missed the compound interest party’ message.

Building wealth takes imagination and flare, not dogma.

(Oh, if you wish to play around with a compound interest calculator, this one is a good one.)

What are your thoughts on compound interest?

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