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Written by Jim Jordal   
Saturday, 26 April 2008

THE "MIRACLE" OF COMPOUND INTEREST

By Jim Jordal

"Scientists have developed a powerful new weapon that destroys people but leaves buildings standing—it’s called the 17 percent interest rate."

Johnny Carson quip about the neutron bomb scare and soaring interest rates, 1980

Compound interest is "the greatest invention in human history," or "the greatest invention of all," or "the most powerful force in the universe," or that "it is more complicated than the theory of relativity."

All these are probably falsely attributed to Albert Einstein, but they make some sense.

The history of compound interest goes back thousands of years, at least to Babylon, the traditional enemy of Israel. What compounding means is the adding of accumulated interest back to the principal so that interest is earned on interest from that moment on (Wickipedia; the people’s dictionary). This is far different than simple interest, which means that the principle remains separate from the interest, which is paid to the creditor at various intervals, and so is not added to the principal amount.

Writers enjoy using examples to illustrate their points. Perhaps the most famous example used to illustrate the effect of compound interest concerns the sale in 1626 of the island of Manhattan by local Lenape Indians to Peter Minuit for beads worth about 60 guilders, or about $24. This transaction (perhaps robbery would be more accurate) is sometimes quoted--along with Thomas Jefferson’s purchase of the Louisiana Territory for $15 million--as the best deal ever made.

But was it such a good deal for Minuit and his Dutch East India Trading Company, or could they have done better? Actually, had Minuit loaned out the $24 at an annually compounded interest rate of 8 percent, by the year 2000 (after 374 years) he would have had a total of $76 trillion, which is more than the estimated value in today’s dollars of all the real estate on this 31 square mile island (from The Rule of 72, by Theodore Hanssen).

Another recent account of the "miracle" of compound interest appeared in Mary Hunt’s column in the St. Paul Pioneer Press for Nov. 19, 2006. The example used was a fictional story of Christopher Columbus who, as he landed in the New World in 1492, decided to begin saving for retirement. If he began with one penny at six percent interest, kept the penny one pocket and placed the interest in the other, after 515 years (2007) he would have the one cent plus the simple interest, or 32 cents. But, had he placed the interest in the pocket with the original one cent, thus allowing both principle and interest to compound, he would after 515 years have had over $107 billion, sufficient for a somewhat improved retirement.

It’s interesting to me that writers refer to the "miracle" of compound interest as if it were an unmitigated blessing with no down side. But a miracle? Yes, for those on the up side, or those receiving the gains from compound interest. But what of those debtors on the down side, who pay the compound interest?

Several writers I studied traced the concept of compound interest to the Sumerians, whose empire included fabled Babylon. Could it be that compound interest and its questionable value is another "gift" to us from Babylon, the kingdom and system against which God declares eternal vengeance?

Although Jubilee justice of the Bible allows no interest to be charged to fellow Israelites, there may be some cases where reasonable simple interest is both just and necessary. Economists use the term opportunity cost to describe the cost of other lost opportunities when money is devoted to one cause, such as making loans. So perhaps a low amount of simple interest would reward one for using money to make a loan rather than spending it upon oneself. And there’s the additional element of risk, which also needs reasonable compensation.

But never should interest be charged on funds loaned to the poor for their subsistence, nor should unpaid interest be used as a reason for foreclosure on productive assets or personal dwellings. Our legal system generally protects moderate home equity from loss in bankruptcy cases, but not against foreclosure due to lapsed mortgages. I wonder why not?

The Jubilee laws of Leviticus 25 contain this command: "If your brother has become poor, and his hand can't support him among you; then you shall uphold him. As a stranger and a sojourner he shall live with you. Take no interest from him or profit, but fear your God; that your brother may live among you. You shall not lend him your money at interest, nor give him your food for profit" (Lev. 25:35-37, WEB).

I wonder what calamities will have to occur before we begin to take God’s commands seriously? Could the present mortgage melt down be a beginning?

So is compound interest a miracle or a curse? Think about it.

Last Updated ( Saturday, 26 April 2008 )