David R. Henderson  

The Miracle of Compound Interest (and Dividends): A Personal Story

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Last summer, I highlighted famous Canadian whisky producer Sam Bronfman's claim that the greatest invention in history is interest. I then posted on how to get rich slowly and drew strongly on the idea of compound interest. Of course, I take the principle to mean compound dividends also; that is, investing in stocks and then reinvesting the dividends in more stocks.

In pretty much every economics course I teach, I love teaching the idea of compound interest. I often tell a personal story to illustrate, and some good news happened a year ago that now allows me to give a very different punch line.

In the summer of 1975, when I was just about to move to the University of Rochester as a newly minted assistant professor in the Graduate School of Management (now the Simon School), a friend wanted to borrow $79, $75 for general expenses and $4 to send a UPS package. I was strapped for funds, not yet having received my first pay check from the U. of R. But he really needed it and told me that when he got back to Missouri, he would immediately send me the $79. I lent him the money.

I never heard from him again. I called him a few times but never got a return call. I gave up.

So that story has been a great one to tell because each year I told it, the amount that he owed me increased. In 2014, for instance, the amount he owed me, assuming an average interest rate of 5%, which is conservative (remember the high single-digit and sometimes double-digit rates from 1975 through the early 1990s), was $530. At a more-reasonable rate of 6%, it was $767. I think I could even reasonably argue for 7%.

So laying this out in class was a fun exercise. I started out with "What if he contacted me now and offered to pay me the $79? What's wrong with that?" Of course, the students got it. What's wrong is that it ignored compound interest. Indeed, it ignored interest altogether.

Then, about a year ago, I was on the phone with a long-time friend. We happened to be talking about friends in the past and he mentioned John, the guy who owed me. Then he told me that John and he are still in touch and John lives in Kansas City. I told my friend that I don't have the warm fuzzies for John because he reneged on a deal. My friend asked more and I told him. "I know John pretty well," he said, "and I'll tell him that he still owes you. I'll give him your phone number, if that's alright."

That was alright. So a few days later, I got a call from John in Kansas City. He felt bad about what he had done and offered to make amends. So I told him my calculations at 5% and 6%. Guess which one he chose. A few days later, a check showed up. Now my story has a happy ending.


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CATEGORIES: Finance




COMMENTS (14 to date)
Joe Carter writes:

The moral of the story: Never loan money to people who think like an economist. ; )

Steve Y. writes:

Justice has been delayed but not denied because he will also be burdened with issuing you Form 1099-INT and a Form 1096 with the IRS in early 2016.

You, of course, as a member of the 1% will not only have to pay Federal and State income taxes but also the Unearned Income Medicare Contribution surtax of 3.8% on net investment income. So approximately half of the interest income ($767-$79=$688) will have to be paid to various taxing authorities.

I know you are glad to be paying the price for civilization, and besides, you didn't earn that!

Maniel writes:

Prof. Henderson,
Your comment about dividends brings to mind considerations relative to the stock market. In particular, companies which return higher percentages of their profits to their shareholders in dividends are often slower growers than those which re-invest those profits in the business. Most investors take this into account, however those who count on the regular dividends are likely to tolerate slower (or no) growth, if they believe the dividend to be sustainable; those who are less financially constrained may choose to pay themselves dividends by selling fractions of their stock which has appreciated (they only buy shares whose value will increase).
The power of compound interest is also related to inflation, appreciation in the price of equities and commodities, and opportunity costs of leaving money in the hands of borrowers in general. 1975 was a good time to place $79 (even more) and some leverage (mortgage money) into US real estate.

MG writes:

Steve Y.

Here is Prof. Henderson's story and he should stick to it. Prof Henderson effectively wrote off the loan in 1976. The $79 dollars became effectively a gift to the friend, but this (I am almost sure) being below that year Gift Tax exemption, meant that Prof Henderson did not have to report it or pay gift taxes on it. In 2015 the friend, out of the generosity of his heart, decides to make the Prof. a gift for $567 -- for which there is not tax form to report and no taxes paid by anyone.

Dave Tufte writes:

I have a similar story. In 1989 a friend begged me for money: he was having an affair with a married woman whose husband was involved in organized crime. He'd been found out, and had to flee town.

For many years I did not get the money back, but it was a more good-natured debt than your story about John.

Perhaps 20 years later one of our friends was murdered. Our circle of friends held a benefit for her children. The 20 year old loan came up in conversation: I suggested, and my friend agreed, that the principal plus interest be donated to the fund we were raising for her children.

Steve Y. writes:

MG, thanks for the gift interpretation of the two payments spaced 39(!) years apart. It's just too bad that Prof. Henderson wrote about them in his blog post as a loan transaction and that he probably doesn't have the technical wherewithal to erase the post from servers everywhere.

I did err in stating that John was required to issue a 1099-INT to David. John is not a "financial institution" and it's entirely on David to self-report the income. A year from now when he does his taxes it will be very easy to forget what happened in early 2015....

Mike Hammock writes:

When teaching compound interest, I like to show a clip from Futurama's "A Fishful of Dollars". Here it is (from 0:00 to around 4:51).

If you haven't seen the show, it may help to know that Philip J. Fry was cryogenically frozen in 1999 and woke up a thousand years later. He now works for a delivery company with some other misfits.

Toby writes:
So I told him my calculations at 5% and 6%. Guess which one he chose. A few days later, a check showed up. Now my story has a happy ending.

I'm hoping that it was 6% because he felt bad and chose the higher amount out of guilt and shame to make amends.

Did he eventually tell you why he did not pay you sooner?

Toby writes:

PS. I am reminded of this post ("The Iron Law of You") by you some time back and I wondered whether it applied here.

http://econlog.econlib.org/archives/2015/02/the_iron_law_of.html

Tom Nagle writes:

John Carter: Did you get the lesson backwards? Isn't the lesson "Never borrow money from an economist"? In my experience, normal people feel guilty about charging interest but not about recovering principal. I would be more likely loan to an economist expecting him/her to realize the time value of money.

David and I were friends in graduate school at UCLA. He was totally broke by the time he left UCLA for his first job. I loaned him money at an good interest rate (don't remember the number) which he promised to repay from his first paycheck. He did. Oven the years since, we have borrowed larger sums from each other on other occasions, benefiting both from the trust and the interest we have earned.

Tom West writes:

This story reminds me of why one of my father's few iron laws was that his children were not allowed to lend money to each other. Give, fine, but lend, no.

Too easy to hurt sibling relations if circumstance or, more often, bad memory intervenes.

Dan W. writes:

David,

You only got paid because your friend, John, was TBTF.

ColoComment writes:

I wonder how long it would take ~$80 at today's rates, even compounded, to increase by more than a rounding error? My prime money market fund's SEC rate* as of today is .01%.
*average annualized income dividend over last 7 days

If that's an easy math question, please forgive: I am a victim of the "new" math of the 60s and have suffered from math learning-deprivation all of my adult life in consequence.

hanmeng writes:

Steve Y.'s snark

and besides, you didn't earn that!
raises a sore point with me. I know it's correct according to the IRS, but in normal English, "to earn" means
to make a profit from business or from money that you have in the bank.
Anyway, I think the fact that your friend failed to pay the money back for so long means he owed you extra, whether you're an economist or a member of the great unwashed.

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