Compounding Interest

June 24, 2015 12:35 pm Published by

 

Real estate investors, or those who fancy themselves to be, sometimes turn for inspiration and gumption to a poem entitled ‘Procrastination’. Penned by an anonymous author in 1918, Procrastination retells the fabled sale of Manhattan Island to Peter Minuet for $26 in 1626. The poem is written from the perspective of the second place bidder who walked away from the deal, deeming it too expensive. He knew the real estate market was over-heated, and determined he would wait for saner prices to prevail. In essence, he was waiting for a recession. The intended message is clear and powerful – I procrastinate at my own peril, and I should prepare to be left behind by those who had more nerve than I.There is a secondary message however, that until very recently entirely escaped me. That message lies not in the action or inaction of the buyer(s) – but rather the future action of the sellers.

Should you find yourself in the position to invest one hundred dollars at 8% interest per annum, in one years time you will have to your name $108 dollars. This seems like a long time to wait to realize an $8 return, and most of us lack the patience to do so. Rather than reinvest, we reap – and at best manage to reinvest only the original principle, happy to harvest another $8 in 12 months time. ( truth be told, the vast majority of us spend the $100 and reap nothing). Rare are the investors who have the staying power and commitment to invest the principle and reinvest the interest. Had the seller of Manhattan Island invested his $26 at 8% – not an unheard of rate of return (and one available today in local Real Estate Investment Trusts – Google Guelph REIT) and had the discipline to reinvest his interest, his original $26 would today be worth $282,000,000,000.00. Yes, that is trillion, and more than enough to buy back Manhattan.

The power of compound interest is undeniable. It is also the most useful mathematical function not taught well enough – if at all- in our schools. Although it has been almost 30 years since I correctly predicted that the high school math class in which I laboured would bear little relevance to the balance of my life, not much has changed. Consequently, the majority of us find ourselves on the painful end of the compound interest lesson. For a select few, the equation f(x)= ax(2)+bc+c may prove to be a useful one. For the rest of us, a far more useful equation would be: pay no interest till 2016= bad. It’s a lesson that the issuers of credit cards and credit in general have learned well, and we subscribers have failed to absorb.

There is no such thing as interest free, except perhaps on your savings account. Interest hidden would be a more accurate statement.

 

Thanks for reading,

 

Jeff Neumann

 

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