the magic of compound interest

Behavioural economics research shows that the human brain is not very good at compound annual growth rates, or CAGRs (pronounced "caggers") as business school students call them.

Behavioural economics research shows that the human brain is not very good at compound annual growth rates, or CAGRs (pronounced “caggers”) as business school students call them.

It seems that there was limited evolutionary benefit for early humans to quickly and accurately know the answer to how many more nuts and berries you could collect if your nut-and-berry collecting skills improved by seven per cent per year for 20 years. Advanced CAGR skills would have done the Halliday ancestors little good as they skulked around Scotland trying to steal those furry Scottish cows from their neighbours.

But CAGRs are important to us today. Our financial lives are governed by them, and relying on instinct can lead us into some big mistakes with serious life consequences. The seven per cent growth rate in the example above sounds minor, but compounded over 20 years it would actually yield a counter-intuitively large four-fold increase.

Some people say that there should be more “financial literacy” classes in school. This wouldn’t hurt, but it might seem as relevant as Caesar’s conquest of Gaul to teenagers who don’t have mortgages, credit cards or mutual funds.

On-the-job training is often more effective than classroom learning. The problem with financial literacy is that by the time you are “on the job” you are usually an adult making big-number decisions about mortgages and credit cards. Often people seek advice from friends and family, who often haven’t taken a financial literacy course either, or the people who are selling the financial products themselves.

If your finances are in order and you have been making up for the evolutionary shortcomings of your ancestors through regular CAGR practice, you can flip to the sports pages to see if the Leafs have already been eliminated from the playoffs.

If not, here are a few classic “on the job” lessons for you.

Lesson No. 1: Mutual funds. Say you have accumulated $10,000 to invest for retirement and you put it in a typical equity mutual fund with a two per cent annual expense fee. Two per cent doesn’t sound like much, and it wasn’t in the boom years when the markets were going up 10 or 15 per cent a year.

But consider a scenario where the market goes up by just four per cent a year for the next 20 years (that’s assuming it does goes up, of course). Applying a four per cent CAGR over 20 years to your $10,000 delivers a nest egg of $21,911. Nice.

But you are also paying two per cent per year in fees, meaning we actually need to apply a two per cent CAGR (four minus two equals two). That reduces your nest egg to just $14,860. Less nice. Your choice to buy a fund with a two per cent expense fee just cost you almost two-thirds of your profits.

Watch your investment expenses, since they can compound unpleasantly.

Lesson No. 2: Credit cards. Credit cards are very convenient, and you can use them for free if you pick one with no fee and pay your balance every month.

The Financial Consumer Agency of Canada has a website highlighting the dangers of unwise credit card use. Many people don’t understand how the “grace period” works. When you buy $100 worth of groceries on Jan. 1, but don’t have to pay your bill until the 31st, you have essentially borrowed $100 for a month. Credit card companies don’t charge you interest on this, unless you pay less than your full balance on the due date.

In that case you pay interest from the date of your purchase, not the day at the end of the month when you decided not to pay your full bill. If you have a big bill and an 18 per cent interest rate on your card, the number can be a shocker.

Furthermore, some people see the “minimum payment” amount on their bill and treat it as a “recommended payment.” As the Financial Consumer Agency points out, if you pay the minimum payment on a $2,000 balance at 18 per cent, then it takes over 30 years to pay off your bill. And you’ll pay $4,931.11 in interest on that original $2,000 spending spree.

If you can, pay your credit card bill in full every month.

Lesson No. 3: Mortgages. Say you go to get a mortgage and they tell you you’ve been approved for the impressive sum of $350,000. Lots of people immediately decide to go shopping for the biggest house they can “afford.” And by afford, they mean the most someone will lend them.

But just because you think you can afford the monthly payments doesn’t mean it’s wise to do it. You may end up signing yourself up for a lifetime of interest payments.

A five-year fixed-rate mortgage for $350,000 at the current rate of about 5.3 per cent gives you monthly payments of $2,083. You might be able to “afford” this, but after the first five year term is up you’ll have paid $86,000 in interest and paid back just $39,000 in principal. You’ll have 20 years of mortgage left.

Meanwhile, if you had chosen a house $100,000 cheaper but made the same monthly payments, your mortgage would be totally paid off after just 14 years and two months. That’s mortgage-free a decade earlier.

Now maybe you like the bigger house, but have you figured out how many thousands of dollars in interest it is going to cost you over the next 25 years?

This column can’t promise you’ll get rich quick. But if you follow the three rules above, you’ll save quite a bit of money.

Keith Halliday is a Yukon economist and author of the MacBride Museum’s Aurore of the Yukon series of historical children’s adventure novels.