Money Growing Just Like Rabbits

Today’s post is by Owuor Kuyoh,  an investment analyst at a local investment bank. He loves to use numbers to tell a story but in this instance he decided to add some words to the numbers. 

I was about 15 years old, desperately saving to buy a new PlayStation2 when my father told me “Money doesn’t grow on trees! You have to put it to work, and then it will yield some fruit.” See, I had tried saving some money through those “Junior “ savings accounts and  what my rudimentary math told me I had in the account did not match the balance the bank told me I had.  They had ripped me off. Thieves! Banks taught me a tough and early lesson on how your money can work for you or for other people.

I have met a number of people, like me, who believed that all interest rates are basically the same. The fact is that they’re quite different and knowing and understanding these differences can make a huge difference in the amount of money you can expect to pay on your loan and make on your investments. Save for the geek maths, most of us retained this formula for calculating interest / earnings:

Interest = Principal * Interest Rate / 100

At some point in high school we were taught something called compound interest, but the formula was so long and complicated, many can be forgiven for forgetting about it right after the exam.  Unfortunately, the banks and other financial institutions use this formula to calculate  large your finance charges are and how much interest you get.

Compound growth means your interest earns interestand makes a deposit or loan grow at a faster rate than simple interest, which is interest calculated on initial amount only. Einstein is said to have once remarked “It is one of the most powerful forces in nature” (compounding), and it’s true. When you have a growing element, which creates more growing elements, which creates even more growing elements… basically you are reproducing like rabbits.

So how does it work?

Say you lend Ksh 10,000 to a friend at 10% interest every year until you are repaid in two years. If you use simple interest, your friend is responsible for paying back the initial amount, the principal, as well as paying 10% on that principal for two years. 10% of Ksh10,000 is Ksh1,000, and times two years is Ksh2,000. So your friend will pay you Ksh10, 000 + Ksh2,000 = Ksh12,000. Suppose, instead of paying 10% interest when the money is given back, you have your friend pay you 10% on the money he still has every year. If he doesn’t pay you back for two years, then you will get 10% on Ksh10,000 in interest in the first year (1,000) and in the second year, he will need to pay interest on the original amount and the first year’s interest (10% of 11,000). At the end of the second year, he will pay you Ksh 12,100, Ksh 100 more than if he had used simple interest.

Compound interest is that simple! (pun intended)

Compound interest is a double edged sword  in that, the longer you invest, the greater the effect of compound interest while the longer you borrow without repaying, the heavier the penalty with time. In our example, the difference is really small because the amount at play is very little and for a short tme, but in the next post we will see what happens when the amounts are larger and saved over a longer time.

For the math nerds; here’s a little trick I learnt in business school, If you want to quickly figure out how long it would take to double your money, use the rule of 72.
72 divided by interest rate = number of years to double your money. If you receive a 6% interest rate, divide 72 by 6, which gives you 12.  This means it will take you 12 years to double your money.  The reverse: If you know you want to double your money in eight years, divide 8 into 72 to find that it will need to find a 9% interest rate to achieve that goal.  A disclaimer however, this method starts to get less accurate for rates over 20% but you’ll still have your rabbits.

So guys, what do you think? Does money really reproduce like rabbits? Let us discuss in the comments section.

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