Jeanette Harris: Compounding the Problem

The subject of this blog will be quite familiar to colleagues at Scottish Book Trust who have the misfortune to sit near me in the office. So I’ve decided to step up on the soapbox and share my grumbling with the wider world.

My soapbox topic is the lack of early, universal teaching of how compound interest works and the consequences of that failing in our collective national knowledge. Not the most exciting of topics, you may think, but, please hear me out ……….

Compound interest is the concept of adding accumulated interest back to a principal sum of money, so that interest is earned on interest from that moment on.

I believe this knowledge is the root of all understanding of how money rolls around and rules the world and without which we are at the mercy of the finance industry gurus. Given that it’s going to be a very long time before we’ll again put our trust in their judgement, it’s imperative that more people are able to ask searching and informed questions about money.

Here are a few simple examples of how compound interest works –

On savings -

a. If I were to save £100 every month for 20 years, at a very modest interest rate of 3%, the total sum saved would be £24,000, the compound interest earned on that sum would be £9,995, so, by magic my £24,000 would turn into £33,095.

b. Being more dramatic, if I could invest £200 per month for 20 years and the interest rate was 8% (seems unlikely right now but it’s not that long ago since such interest rates were the norm), my total sum saved would be £48,000, the compound interest would be £71,347, and my £48,000 would become a whopping £119,547.

On borrowings –

a. I want to refurbish my kitchen and take out a loan of £10,000 to satisfy my craving; I’ll pay it back over 5 years at an interest rate of 6%, ie £3,382 so the total I’ll have to repay will be £13,382 – but I can still only spend £10,000 on my kitchen.

b. Going a bit higher up the scale, I buy a house costing £200,000 and need a mortgage to be repaid over 25 years; I don’t have much of a deposit so the best rate of repayment interest I can get is 4.5% (assume that’s fixed). By the end of the 25 years I will have repaid £133,600 in interest and the house will actually have cost £333,600.

Of course there is a whole raft of other options and circumstances around savings and borrowings, but I hope you’ll find these examples quite amazing.

Have some fun with this calculator website. If you start with large sums you’ll soon see why the rich get richer!

Anyone who gains a good understanding of compound interest will automatically have a real grasp of how money works, how the financial industry operates and how our everyday lives now and in future, are affected by this amazing phenomenon.

Questions which keep me awake at night …..

Q1. Armed with this knowledge, would more of us have been motivated to question what was going on in banks and stock-broking houses in the lead-up to the spectacular banking collapse and resultant recession, especially the excessive rewards which finance industry chiefs were handing out to themselves in return for failing performance, whilst their poor customers suffered plummeting savings rates and returns on investments, rocketing interest rates on borrowings and in many cases, financial ruin?

Q2. Could closer, informed questioning of these actions by customers have forced a review of finance house practices and even evaded the banking collapse which resulted in this deepening recession?

Q3. Do those finance industry chiefs, on whom we have all relied to look after our and our country’s money, understand compound interest any better than the majority of the general public?

Q4. If they do, then have they wilfully, uncaringly and deliberately led us into a recession, thinking they would be protected from and immune to personal ruin?

Q5. If they don’t, how on earth, and by whom, were they appointed to positions of such responsibility in the first place - and why were they not found out?

In my more sceptical moments I wonder if (whether by intention or by default) the major banks and financial institutions have traditionally relied on the ignorance of the majority of their customers to control the industry for the benefit of some of its employees and shareholders rather than customers. I have certainly never had compound interest explained to me by any bank, whether as a borrowing or saving customer.

But none of this makes any sense. You don’t need to be an economist to work out that a healthy balance, high savings rates and low borrowing rates make the world go round.

High returns on savings encourage more people to save more - banks profit from investing (customers’) savings on the international markets; low borrowing rates encourage more people to borrow more – banks profit from repayments of customer loans; people save and borrow money to buy goods or property; businesses benefit from selling more goods to more customers and then borrow with confidence to expand – banks profit from repayments of business loans. The obvious point of note here is that banks stand to profit in all of the above scenarios.

So my final question Q6, is – if all the above does makes sense, why did our banks get it all so wrong?

Could the answer be that most people working in the banking industry have never truly understood COMPOUND INTEREST just like the rest of us?

Scottish Book Trust has been doing its bit over the years to encourage young people to manage their money and improve their financial literacy with two projects – On The Money for primary school pupils and Skint! for 16-25 year olds.