There is a quote that is often attributed to Albert Einstein that “compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it”.  The quote comes in other variations that compounding interest is “the most powerful thing in the universe” or “the greatest invention in human history,” concluding that “not one in a thousand understands it”.

Regardless of the wording or authenticity of the quote, the sentiment stands.  And so does the power of compounding interest.

But it is a knife that cuts both ways – compounding interest can work for and against you. It can be the chains that bind us or the means by which we break free.

Banks understand this. They also understand that the debtor is slave to the lender.  

Governments also understand the power of compound interest.  This is why they feign concern for our financial welfare with laws like the Consumer Protection Act and the Truth In Lending Acts.  Well, it is axiomatic that whatever a law or bill is titled, you can be sure that it will do the exact opposite.

To combat the practice of usury, the 1968 Truth in Lending Act was passed.  This law requires lenders to provide consumers with standardized information about the terms and costs of loans.  But is it providing the whole truth, or just what makes it seem like a good deal so you sign for that loan?

The Truth In Lending Act did standardize the information presented.  But it also shifted the consumers focus to only one part of the equation – the number in front of the percent sign.  What about the other terms, particularly the length of the loan and the total volume of interest paid?

That 5.3% Annual Percentage Rate (APR) mortgage sounds like a good deal, doesn’t it?  It doesn’t seem exorbitant in that context.  It’s a mid-low single digit number, right?

Commercial financing packages do not generally list an APR.  Instead of agreeing to a rate, the business owner is agreeing to a volume of interest (time price differential) and he is expected to be able to understand and be able to calculate the total interest rate and the APR for himself – if he even cares about the number. I guess government thinks business owners are smarter than the rest of us and we need to be “protected” from the evil bankers (who lobbied for the Truth In Lending Act) by showing us the APR.

Does that 5.3% still sound so good on a 30 year note?  Maybe. What if you recognized 5.3% over 30 years meant paying $400,000 for a $200,000 house?  Doesn’t sound so good now, does it?

Consider a car purchase – the auto dealer is offering 0% financing!  How generous!

There is no such thing as a free lunch.  And the auto manufacturers make more money on financing cars than they do building them.  Make no mistake, the dealership is not giving you anything for free.  All the interest they would have earned on your 5% APR 72-month note is just added to the price of the vehicle and offered at 0% financing.  This just takes away your ability reduce the interest paid by paying off the loan early.  You give up more control.

How’s that for “Truth In Lending”?

In Becoming Your Own Banker, Nelson Nash demonstrates that for most Americans 34% of every dollar we spend is lost to finance charges.  Consider your mortgage.  A $200,000 mortgage with a 30 year note at 5.3% will cost you $400,000 over the term.  That 5.3% APR equates to $200,000 by volume and 50% of every mortgage dollar goes to interest.  You pay 100% of the price in interest over 30 years.

Thanks to the Truth In Lending Act, we focus on the 5.3% and forget the $200,000!  Now you tell me, which one is more important – APR or volume?  Does 5.3% seem exorbitant when applied to a 30-year mortgage?  Now consider that the idea of 40- or 50-year mortgages has been floated in America and already exists in the UK.  Japan even offers 100-year mortgages.

The numbers only get worse if you’re selling in the first half of the mortgage when payments are more interest than principal.  How often are our military members given a permanent change of station?  If you buy that home and move after 3 years, 77.9% of your $1,111 mortgage payment will be going to interest, reducing the loan balance to $191k. 

The average American moves every 5 years – 76.7% of your $1,111 mortgage payments will be going to interest, paying the mortgage down to $184k.   

If you were able to finance it yourself, making the same monthly payments, you would reduce the principal to $179k in the same 60 months while paying $4.8k less in interest.

If you practice Becoming Your Own Banker, you can reduce your reliance on third-party capital and put the power of unbroken compounding interest to work on your side, not the bankers’.  Instead of merely making the financial engine turn profiting other people and giving up control of your capital, you retain control and make your personal financial engine grow.

If you’re ready to control the power of compounding or just want to learn more, click to book a free call with an advisor today.

Semper Reformanda

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