Compounding: Are You Smarter Than A Third Grader?

Have you ever felt sleep deprived? As in, to the point where you crave nothing more than your head hitting that sweet pillow and falling into deep slumber?

The worst of my sleep deprivation was after my third child was born. I figured with my first two, I probably knew what I was doing with raising children. I was, after all, a full-time stay at home parent. I didn’t necessarily feel completely competent, but enough to know that I could at least keep them alive and loved (that’s enough, right?).

Then baby #3 arrived. I have since come to the conclusion that she didn’t like being a baby.

I’m not sure why she was so unhappy. She liked to cry. A lot. I did a lot of baby-wearing. And a lot of pacing with her in my arms, willing her to please sleep for just a little so that I could get some rest myself. We ruled out any medical issues, so I knew that there was nothing physically wrong with her. She just happened to cry a lot more than my other two kids. To top it all off, she was a poor sleeper, waking up multiple times in the middle of the night for well over a year. Dream feeding didn’t help. Cry it out didn’t help. Nothing any of the books told me helped. The sleep deprivation that had started with my first pregnancy compounded, to the point where by the third baby, I became a walking zombie (she is now a very happy-go-lucky child, thank goodness!).

BAD NEWS FIRST- COMPOUNDING AND STUDENT LOANS

This might be how one feels after getting out of vet school when it comes to your student loans. At first it doesn’t seem so bad. You take out some loans because tuition and fees are high, but that was expected. And you’re confident that you’ll be able to pay them back, eventually. But each year passes, and you see that number go up as you need to take out even more loans. You start to realize that interest rates really matter, especially the larger your loan amount.

Each day that you keep that loan, it goes up according to a daily interest rate calculation. Here is where you see compounding in action, as interest builds on interest. Using the VIN Foundation’s In-School Loan Estimator, this is what happens when you borrow a total of $100,000 ($25,000 for each year):

• Total Loan Balance at Graduation: $112,479 (with a 6.59% interest rate)
• If repayment starts after the 6 month grace period, the new balance: $115,726

You borrowed exactly $100,000, but with the combination of the interest rate and the passage of time, another 15% was added onto your balance 6 months after graduation. Ouch.

Click on this link for a great explanation and graphic on how your student loan interest rates are calculated and compounded over time.

NOW THE GOOD NEWS- COMPOUNDING AND YOUR SAVINGS/INVESTMENTS

OK, so that was kind of depressing. But math can work in your favor too! In fact, compounding has been called the eighth wonder of the world because of what it can do to your savings/investments over time. Now, we’re looking at money that you have, not money that you owe. And money that you have can grow exponentially under the right circumstances.

Let’s imagine a scenario where instead of $100,000 in student loans, you have $100,000 in the bank. To make the math easy, let’s assume a lump sum of $100,000 at a 7% interest rate. Here’s what you get at the end of 4 years:

• Interest compounded daily: $132,310
• Interest compounded monthly: $132,210
• Interest compounded annually: $131,080

If this were a simple interest calculation, as opposed to the compounded interest calculations that you see above, you would have $128,00 at the end of four years ($7,000 in annual interest multiplied by 4 years).

As you can see, compounding frequency has a significant effect on total interest, despite keeping the same interest rate. You can also see what a difference compounding makes compared to a simple interest calculation.

THE RULE OF 72

Want a quick way to figure out how long it would take to double your investments? Enter the Rule of 72.

72 is divided by the rate of return, and that will give you an approximation for how long it will take for that investment to double.

If you have an expected rate of return of 10%, then your investment will double in 7.2 years (72/10).

If you lower this rate of return to 3%, then the investment will double in 24 years (72/3).

Rate of return and time are huge factors in compounding.

INVEST EARLY AND OFTEN

The magic of compounding can only be appreciated fully when you’re looking at a long time horizon. A popular example is one made famous by Dave Ramsey. He takes Ben and Arthur, two friends who invest the same amount of money, but started at different ages and invest over different time periods.

Ben started investing $2,000/year at age 19. He invested in mutual funds that returned 12%. He then stops investing at age 26, so he has put in a total of $16,000.

He lets that money sit pretty while he lives the rest of his life. Fast forward to age 65, and now he has a whopping $2,288,996! All thanks to compound interest and time.

His friend Arthur also invests $2,000/year with 12% returns, but he started at age 27. He invests every single year until the age of 65, so the total amount he invested was $78,000. His grand total? $1,532,166.

Not a shabby number, but when you look at how much more he put into his investments ($68,000) and the fact that he accumulated so much less in comparison to Ben (over $750,000), it’s clear that the amount of time the money is invested is a huge factor due to the magic of compounding.

**HUGE caveat here: These numbers aren’t realistic because you’re never going to have an investment that guarantees a 12% return every single year for decades. It just isn’t going to happen.  This is just a way to drive home the idea of compounding and investing early and often. Reality is much messier than this very tidy example, and if you’re a bad investor, you could very well lose money. Don’t be a bad investor.

VETERINARIANS ARE LIKE ARTHUR

Unless you were lucky enough to have grandparents or parents who started a savings account for you as a child, or if you were lucky enough to be financially savvy and start investing on your own at a young age, you’re probably an Arthur. The extra years of schooling to get your veterinary degree puts you at a disadvantage compared to your peers since you won’t have access to employer retirement accounts like a 401(k) until you graduate from vet school (although you do have access to IRAs as long as you have earned income!). Just being a veterinarian puts you at a disadvantage because your primary focus is not on business and finance, but it’s on providing quality veterinary care. If you were that interested in finances, you would have pursued a different line of work.

I definitely fell more into the Arthur camp than the Ben camp. I didn’t start investing until AFTER vet school, because I was clueless. In fact, I only really started investing after getting married because my husband started investing for me. I was scared of investing and didn’t have any interest in learning more about it. I think I took exactly one economics course in college- Econ 101. Literally, the only thing I remember is the supply and demand graph. So not helpful in this case.

You know what would’ve been really helpful? A personal finance course. Why they don’t teach these principles starting in grade school is beyond me. According to this article, there are 5 states that mandate that high school teach a personal finance course for at least half a year (Alabama, Missouri, Tennessee, Utah, and Virginia).  I feel like this would have been a lot more useful than trigonometry.

ARE YOU SMARTER THAN A THIRD GRADER?

As I was working on this post, my third grader came up and asked what I was working on. I seized the opportunity, and in less than 5 minutes, she understood the concept of compound interest. Here’s the example I gave her as we worked this out on a piece of paper and a pencil:

Me: You have $100 in the bank. The bank is thanking you for giving you that money in the form of interest. Let’s say they give you 10% every year (I wish!). How much will they give you after 1 year?

Third grader: $10

Me: OK, so how much do you have in total?

Third grader: $110

Me: Good. So another year goes by. What is 10% of $110? (Remind her of the trick to move the decimal point over by one.)

Third grader: $11

Me: Great! So how much do you have in total after 2 years?

Third grader: $121

Me: See how compounding works? Your money can grow really fast! And you didn’t even do anything other than put $100 in the bank and wait for 2 years!

Third grader: Cool.

Then she goes on to ask how the bank is able to give you that much in interest. I tell her that 10% is A LOT and no bank is ever going to give you that much. More like 0.01% in a regular savings account. I tell her how banks are also lenders, and the amount they can charge on interest for money that is borrowed will more than pay for the amount of interest they will pay out. Of course, this is very simplified, but it drove the point home.

Isn’t it crazy how most adults don’t understand this concept? Something that took less than 5 minutes for a third grader? Seriously, way more practical than trigonometry.

CONCLUSION

So don’t discount the power of compounding. Remember that it can both work for you and against you. If you want it to work for you, then start investing early, make some smart investment choices, and leave the money alone to see compounding to its fullest potential. Don’t know much about investing? Read this first to get used to the concept of investing.

How do you prevent it from working against you? Ideally, you would have minimized the amount of loans you borrowed during school. Choose the loan payback strategy that makes the most sense for your situation. Don’t rack up credit card debt. In fact, try not get rack up any sort of debt without a good strategy for paying it back. Because those banks and lenders are more than happy to collect those interest payments. And I have a feeling you’re wanting to do more with your money than pay the bank a lot of interest.

Third grade math, solving grown-up problems.

 

How have you seen the effects of compounding in your life? Comment below!