The Most Powerful Financial Lesson I've Ever Learned
May 29, 2009
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While there's some doubt as to whether or not Albert Einstein actually quipped, "The most powerful force in the universe is compound interest", I can't think of a more profound financial lesson. In fact, were I able to teach our young daughter one and only one financial concept, it would most assuredly be this one.
Anyone who's spent any time around The Motley Fool has certainly run into this lesson many times over -- and for good reason. It's fundamental to understanding how nearly everything involving money works -- from credit cards, to home and car loans, to bank accounts, investments, you name it.
In fact, in what now seems a prior lifetime when I was in my 20's and managing movie theaters for a living, some of the teenagers who worked for me probably thought me a bit odd as I would rather often try to teach them just how powerful compound interest can be, both working for them and against them.
Frankly, if only more of us truly understood this fundamental concept, a good bit of the financial turmoil we are facing could have been avoided.
Sure, we've all read the articles declaring just how much $100 per month invested at, say, 10% per year in the stock market can grow to after 20 years (by my math, the $24K invested will grow to about $72,400). Some of you might argue that the 10% figure is too high, and fair enough, but the concept remains the same. Exponential functions are powerful things.
While I think most people understand this aspect of compounding, I think all too few seem to understand the flipside -- that the exponential nature of compounding is no less powerful when it works in the opposite direction.
Here is, perhaps, in a single sentence, the most powerful financial lesson I have ever learned:
Avoiding paying interest is the same thing as earning it.
Okay, for those of us who've hung around The Motley Fool for a while, this is 'old hat', but it sometimes amazes me how powerful the implications of this simple lesson are.
I'll never forget when I was just getting started in my adult life (back when I was preaching the power of compound interest to kids pouring artificial butter flavoring on overpriced popcorn). Sure, I had a credit card in my wallet, and sure, there were lots of things I would have liked to have had that were but a swipe of the plastic away... but every time I considered prying the card from my wallet I'd remember the above lesson. "Why, on earth, do I want to pay 20+% interest? If avoiding paying interest is the same thing as earning it, how much is that shiny whatchamacallit going to cost me in the long run?"
Now, I did, from time to time, use my credit card back in those days. Most often it was because I was driving an older car that needed repaired from time to time. Unfortunately I wasn't, yet, financially savvy enough to build-up an emergency fund, so when my car did need repaired I had to whip out the plastic -- after all, I did need transportation to and from work and school. When that bill did arrive in the mail, though, I paid it with a vengenance. No, I couldn't always pay off the entire balance, but I would always pay off as much as I could.
In fact, I guess one could say that I dislike debt. Frankly, it makes me feel uncomfortable. I dislike knowing that, in the long run, I'll have less money, and fewer shiny whatchamacallits to enjoy because of it. This doesn't mean that I have no debts today -- I have a few -- so maybe 'dislike' isn't quite the word. But I like to think I have a profound respect for it. Like many powerful tools, it can be used and misused and one has to be ever careful one is engaging in the former rather than the latter.
I keep hearing news stories about the state of our economy that seem to talk about the failings of our debt-driven economy -- that much of our economic growth over the last few/several years (if not longer) has been fueled by consumer debt, and this reduction in consumer debt is at least partially responsible for our contracting economy. While for those who've lost their jobs it may come as little comfort, in the long run, I can't help but think this is a good thing. After all, what works for one of us works for all of us. If we, as individuals, will find greater financial prosperity by utilizing less debt, then we, as a country and economy, should also.
Of course there's one debt I still owe which was probably the singlularly greatest financial decision I've ever made in my lifetime -- and that's the outstanding balance on my student loan from grad school. The difference that education has made in not only my earning power, but in the quality of my life, far outweighs the cost. That is, indeed, an example of debt used to fund a true investment -- an investment with a greater return than the cost of the debt used to fund it. Okay, I realize I'm starting to ramble here, which wasn't my intention... but I bring up this point because I all too often hear politicians say "We have to invest in this or that" while I know they'll be utilizing debt to do so -- and, of course, all too often that so-called investment is anything but. Now, I'm not suggesting that the particular government program in question isn't worthwhile, worth doing, or perhaps even worth utilizing debt to do so.
But I think, all too often, our government makes the same mistake many of us do -- failing to realize that in the long run we'll have more of the things we want our goverment to provide us by using less debt.
All right, I suppose I've rambled seemingly endlessly for long enough -- especially over a topic that is likely well known by just about everyone who's spent any time here at The Motley Fool...
But when the time comes to begin to teach our daughter about money and finance (she's just shy of five years old now), I'll start with the lesson that, whether Einstein said it or not, compound interest may just well be the most powerful force in the universe -- and avoiding paying interest is, financailly, pretty much the same thing as earning it.
Regards,
Russell (a.k.a. TMFEldrehad)
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