Monday, August 18, 2014

Payday Lending: Compounding A Problem...

When folks talk about human intelligence, quite often the first name mentioned is Albert Einstein, the original "Master of the Universe", with the theory of relativity - E=mc2 and all that.

Some may not know that Einstein was also financially shrewd and astute, famously noting that "the eighth wonder of the world is the power of compound interest".  It does seem somewhat miraculous how quickly compound interest can increase a pool of savings.

A great "rule of thumb"  for estimating growth
Fast money... !!
related to the compounding power of interest is called "The Rule of 72".  If you know the interest rate on an investment, then divide it into the number "72" and the answer will tell you approximately how many years it will take to "double your money" at that interest rate. Here's an example - an investment earning 12% will double in value in 6 years (72/12 = 6).  Equally an investment earning 9% would be worth twice as much in 8 years (72/9 = 8). Got it?

But perhaps a better example of the power of compound interest is to look at the growth in dollar terms. If that long lost, rich uncle had invested $10,000 at a 12% return (quite possible in a well-selected growth stock portfolio) for you when you were 10 years old, how much money would you have accumulated when you were ready to retire? Go ahead, take a guess!

Collecting pictures of
Ben Franklin!!
Well, let's see how it adds up.  It's going to double in value every 6 years (72/12 = 6).  So, at age sweet 16 (got the fund at age 10 and 6 years later you are 16!) the value has doubled to $20,000 and at age 22 ( 6 more years later!) it has doubled again to $40,000! Fast forward: age 28 = $80,000; age 34 = $160,000: age 40 = $320,000; age 46 = $640,000; age 52 = $1,280,000; age 58 = $2,560,000; age 64 = $5,120,000!!! Would make for a nice retirement - right!  Even at 8 or 9%, you would be sitting on a cool million dollars or so!

But according to Einstein, everything is relative....!!! 

So, if compounding "upward" on savings is "the eighth wonder of the world" for wealth building; then what should we call....

Payday madness!
... "downward" compounding on payday loans and overdraft protection plans with truth-in-lending validated interest rates of 400% to 800%?  

Let's see? Using the Rule of 72, how long does it take to cut your wealth in half? (72/400 = .18 !!) Well to be fair, let's round up to 1 year. Now using our "$10,000 at age 10", rich uncle example above, at age 11 you would have $5,000; at age 12 = $2,500; age 13 = $1,250; age 14 = $625; age 15 = $ 312; and at Sweet 16 you can't even afford to go to the prom....

It doesn't take a genius to figure out that 
payday loans
are financial weapons of mass destruction.
Aren't we glad credit unions look after their members!!

1 comment:

Anonymous said...

Jim, We've done payday alternative loans for years. Our overdraft fees have gone down significantly as a result. Pre-funding a shortfall is better than countless dings for one error. I blame it on the damn debit card... too much access and not enough balancing ability.