Saturday, May 24, 2014

Increasing Creativity Part 1: Compound Interest, An Applicable Financial Concept

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Books and articles about personal finance often bring up compound interest. Put simple as I can: When a bank pays a consumer interest on money in their savings, checking, CD or whatever account, the bank deposits it into the same account.

If kept there, the bank continues to pay interest on deposits. They will also pay interest on previous interest deposited into the account. Each time the bank pays interest in the future, they will pay for both consume deposits and previous interest they had deposited into the account.

Here's an example with numbers:

On January 1 consumer puts $10,000 into an account that pays 12% annual interest (good luck with that! I'm trying to keep this simple). The interest breaks down to roughly 1% a month. For simplicity, let's just say every month is 30 days. Let's also say the rate is fixed. It doesn't increase or decrease (again, simplicity, folks!).

On January 30, bank deposits $100 into account to pay the 1% interest on the consumer's original deposit $10,000. If the consumer doesn't withdraw or deposit anything, next interest payment deposit will be based off $10,100.

February 30: Payment of $101. based off $10,100 in account and 1% monthly interest. End balance: $10,201.

March 30: Paid $102.01 End balance: $10,303.01.

April 30: Paid $103.03 End balance: $10,406.04.

May 30: Paid $104.06 End balance: $10,510.10.

June 30: Paid $105.10. End balance: $10,615.20.

July 30: Paid $106.15 End balance: $10,721.35.

August 30: Paid $107.21. End balance: $10,828.57.

September 30: Paid $108.29. End balance: $10,936.85.

October 30: Paid $109.37. End balance: $11,046.22.

November 30: Paid $110.46. End balance: $11,156.68.

December 30: Paid $111.57. End balance: $11,268.25.

Over that one year after the consumer deposited just the original $10,000, the bank paid them $1,268.25 total interest.

Before I knew better, I would have calculated interest on a straight 12% for a year. Done that way, interest payments on that $10,000 would come to just $1,200.00.

Getting interest payments monthly at 1% compared to a straight annual 12% gets $68.25 additional through the whole process. $68.25 doesn't sound like much after putting in $10,000 and also getting $1,200 in interest payments. It isn't if we just take into account that one year.

What happens if we ran those numbers for 12 years, though? I won't show my work like above. Instead I'll just jump to the conclusion.

Total interest at 12% straight interest annually for 12 years on originally $10,000 deposited: $28,959.76. End Balance: $38,959.76.

Total interest at 1% compound interest monthly (12% annual paid every month at rate of 1%) for 12 years originally $10,000 deposited: $31,906.16. End Balance: $41,906.16.

That $68.25 one year additional from compounding turns into $2,946.40 after 12 years. Maybe not up there like $30,000 or so but still a pretty good chunk of change. Every little bit counts.

Compound interest works to the consumer's benefit when the bank pays it. It loses its fun when borrowing through credit cards. Instead of getting paid more thanks to compounding, the consumer ends up paying more to the bank because of compound interest.

For the sake of simplicity, just reverse the calculations above. Most banks require initial payments soon after they issue a loan. Imagine that the bank makes a deal with the consumer that they don't have to make their first payment in the first year or in the first twelve years.

For the one-year deal, the consumer pays $68.25 extra because of compound interest. For the twelve-year deal, the consumer pays an extra $2,946.40. Who wants to pay that much just for the privilege of using money and not having to make their first payment for awhile? The consumer could have used that money to pay down the balance.

Compound interest has the bank paying the consumer interest on accrued interest in deposit accounts. A phenomenon that yields some amazing results.

On the other hand, compound interest also has the consumer paying the bank interest on accumulated interest in loan accounts. A frustrating process that makes paying back credit cards and other loans so difficult.

Reality makes the process more complicated. For deposit accounts, the consumer could deposit and withdraw during the process. Each month has a different number of days, which affects the monthly interest payments.

For revolving loan accounts, the consumer could charge and will pay back the loan during the process. The days in the month also affect the interest charged to the account.

Things get even crazier, for better and worse, when it comes to shares in mutual funds, stocks and other products that reinvest dividends and capital gains. Since the value of shares change day-to-day or even moment-to-moment, the re-invested dividends and capital gains can mean losing more or less money every second as share value changes.

The consumer can even buy and sell shares to take advantage of fluctuations to create their own manual compounding process (timing the market this way not suggested, even though I try to do it sometimes -- let's just say I didn't reap the high 30% gains that many passive investors did in 2013). Much more complicated stuff.

Using compound interest and other financial methods can help grow wealth. A lot of wealth can help free up time and provide freedom tocreate. All well and good. I follow these practices to reach that point. If you try, too, I commend you.

For this series of entries, thogh, I plan to port the concept of compounding from the financial field into the field of creativity. Unlike a bank account and interest, compounding in creativity doesn't happen automatically. It requires adoptiong personal habits and taking actions. It requires fighting inertia. After building some momentum, though, it could almost feel automatic.

I'll delve a little deeper into practices that compound creativity in the next couple of entries (at least soon to be posted entries).

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