How I explain compound interest without using math

Infamously captured in The Wolf of Wallstreet, the “Sell Me This Pen” tactic is as old as black pepper. The premise is that one person gives another person a pen, and then asks them to sell it back to them.

If you have a Sales background like me, you’ve probably experienced it in an interview setting or training course. It’s one of those trick questions because the obvious response of just describing the pen isn’t the right one.

Savvy sellers know not to treat the pen like a commodity.  We avoid talking about the features of the pen and instead, use the pitch to learn more information about the buyer. We’re taught to use that information to our advantage and reframe the same pen in a way that creates a new demand for it. Just like that…voila, SOLD!

sellmethispen

When it comes to interest, we are all willing participants in a similar exercise called “Sell Me This Dollar”. The construct is simple: we are the buyer and creditors are the seller. We have a dollar and they try to sell us that same dollar.

Creditors are some of the savviest sellers. They learn what we like (Travel! Gas! Discounts!) and they use that information to reframe our dollar and create a new demand for another currency like points. When it comes to interest, they reframe it as more time. This lets them charge you for the dollar and the time. 

Einstein called compound interest the “eighth wonder of the world” and he’s right because interest is like magic.

Magic is a powerful form of entertainment.  It has been called the world’s 2nd oldest profession and the richest art form because of the conflict it creates in your brain. The essence of what makes something magical is subjective, but a commonly accepted theme is that it makes you see something that really isn’t there or miss something that really is.

The science behind it is that a magician purposely guides your attention to the wrong place so that the trick can happen. 

Now you see it, now you don’t. 

Creditors use this same sleight of hand technique to convince you that you’ve bought “more”; but you’re really just buying your own dollar back, with interest.

Ok, so what’s Interest?

Interest is the hidden-in-plain-sight cost of your purchasing power. It’s either working for you or against you. Click To Tweet

If you’re scared of math, here is the easy way we think about interest in our house: any percent of any dollar that is not working FOR us is expensive.

We like calling it expensive because expensive is a relative term that has very little to do with affordability.  And ‘expensive’ is provocative enough to pivot the conversation from cost to value. 

It sounds abstract, but finding ways to anchor all of our financial discussions to value has been an effective hedge against lifestyle inflation. In general, we find “is it worth it?” creates a much richer discussion than “can we afford it?”.   

It’s still hard sometimes because industry has conditioned us to use qualifiers like “good” and “bad” to separate debt that has leverage from debt that doesn’t; but no matter what you call it, it almost always has interest. That’s where the true cost is. 

For example, got some “good” debt in the form of a 30 year mortgage? Expect to pay average of 67% more than the loan amount because of interest. Have you been faithfully paying some “good” student loans but are noticed the balance isn’t going down? That’s because the true cost was buried in amortization tables and then distilled into friendly installments.

The reality is that you may be able to afford to make the monthly payment, but that doesn’t make it any less expensive. Click To Tweet 

And I get it. In a country where the interest you owe can be used as a tax break, it all feels normal. Once we understood the alternative where we could earn interest instead of paying it, it started to feel naive. Absurd, at times.  

Tax implications can change at any point with any administration, so we play the long game. Using the the Rule of 72 as one of our guiding principles made it easier for us to build a wealth strategy that assumes that a decision to sell a dollar through investing instead of buying it back through debt is a good decision. 

Again, I GET IT. The reality is that most of us regular folks can’t just avoid paying interest altogether; but understanding how expensive a decision is at the forefront is a life-changing practice. Thanks to regulatory laws and fine print, the only thing you have to pay for this level of insight is attention.

Seriously…do your Googles! there are calculators everywhere

That’s why this isn’t an anti-capitalistic rant or a Ramsey-style sermon vilifying credit. We simply realized we could tilt the odds in our favor by becoming more conscious consumers. With larger purchases we shop around for lenders so we can be discerning about the terms of the loan. We also practice aggressive patience, pay our credit cards off every month, and subscribe to a Wu-Tang debt philosophy of C.R.E.A.M. (Cash Rules Everything Around Me)  

Understanding that interest can either compound for us or against us is what created the urgency that fueled our 5 year debt payoff. It diversified our investment strategy to include more low-cost index funds and tax deferred savings vehicles, as a complement our existing real estate and employer funds. As a bonus, it also made us approach our budget with discipline and free up more cash to invest.

Bottom line: watching our money work for us reminds us of the authority we have in our life vs. our employer.  Achieving financial independence really is an exponential process and turning a little bit of learning into action compounds an astounding rate. 

Mrs. r&R

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