There are people who think that compound interest is evil and unnatural. Therefore, it should be banned in favor of simple interest.
In this article we will analyze whether banks who lend us money at compound interest do so because they are greedy or because compound interest is the natural mathematics.
Banks (as far as I know) are greedy and insatiable.
Good! Now we just need to look at the mathematical question. Let’s use a fanciful example.
You and your best friend own a small shop. One day, your partner says the store needs to spend $10,000 on a renovation. For this, the store needs to borrow $10,000 to repay after 3 years.
You go to the financial market. There are only two banks: NiceBank and EvilBank. Both are willing to lend $10,000 to your store. Both charge 15% per year as interest. Both charge interest together as principal at the end of the loan period. EvilBank works with compound interest. NiceBank works with simple interest.
In no way you will pay compound interest to EvilBank. You run straight to NiceBank. The banker welcomes you, but says he only lends money for 1 year. The conditions are good, excepting the deadline which is very short. You don’t do business.
As the store needs capital, you go to EvilBank and borrow $10,000 at COMPOUND interest of 15% per year during 3 years:
- Now you receive $10.000.00.
- End of first year you owe $10,000 .00 * 1.15 = $11,500.00.
- End of second year you owe $11,500.00 * 1.15 = $13,225.00.
- End of third year you owe $13,225.00 * 1.15 = $15,208.75.
- You pay off the debit: $15,208.75.
- Total interest was $5.208,75.
You and your partner happily begin reforming the building. Soon you discover that you have underestimated the expenses and need another $10,000. This time, to pay after 1 year.
No problem. You go to NiceBank and borrow $10,000 at SIMPLE interest of 15% per year during 1 year:
- Now you receive $10.000.00.
- One year later you owe $10,000 .00 * 1.15 = $11,500.00.
- You go to NiceBank and pay off the debit: $11,500.00.
- Interest was $1,500.00.
- Before you leave the bank a tsunami floods your city. You know the shop will need a very strong reserve to survive. So, you ask NiceBank to lend you again, the most, the better. NiceBank agrees to lend all the money you paid today, in the same conditions as before.
- Now you receive $11,500.00.
- One year later you owe $11,500.00 * 1.15 = $13,225.00.
- You go to NiceBank and pay off the debit: $13,225.00.
- Interest was $1,725.00
- You are worried about a new aggressive virus that makes the economy collapses. So, you ask to lend again, in the same conditions, all the money you used to pay the bank. NiceBank agrees.
- Now you have $13,225.00.
- One year later you owe $13,225.00 * 1.15 = $15,208.75.
- You go to NiceBank and pay off the debit: $15,208.75.
- Interest was $1,983,75.
- Total interest was $5,208,75 ($1,500.00 + $1,725.00 + $1,983,75).
In both cases the total interest is exactly the same!!
Compound interest is the way math works.
You may not like to pay compound interest. But you receive it in all your credit investments.
The greed is in not in the compound interest. The greed is in the interest rate and in some abusive clauses.
To be continued
The next article is “The Problems With Growth Stocks”.