Here's a short story to explain what compound interest is to those who may not be familiar with the term. The story will revolve around the interaction between two characters; Gary the Gambler and Larry the Loanshark.
Gary the Gambler lives in Anytown, USA and has made a nice living as a insurance representative. Gary is married with three children and doesn't drink, smoke, or use drugs.
But Gary has a vice, he likes to gamble.
Larry the Loanshark works in "Waste Managment." He moonlights as a bookie taking friendly wagers on sporting events. Larry also provides loans to those who are not approved by a bank or or who prefer not to use one. Larry charges a slightly higher rate of interest than most banks will. Our government calls this usury, but Larry likes to think of it as a public service for the less fortunate. Often times, the people who cannot pay Larry on the wagers they lose will take out a loan with Larry, a convenient way for Larry to kill two birds with one stone.
When people don't pay Larry, he becomes agitated. After several weeks of non-payment Larry sometimes has to take matters into his own hands. To prevent this from happening as much as possible, Larry the Loanshark charges his clients 25% of what is owed to him already every week they don't pay -- referred to as interest.
Larry then adds that interest to the money -- referred to more commonly as the principal. When Larry adds the interest to the money owed, he is compounding the interest to what is owed to him, hence the term "compound interest". This is not to be confused with "pounding" which is what Larry will often do to someone's kneecaps if they refuse to pay him.
Lets flash forward to week 5 of the NFL season. Gary the Gambler is on the phone trying to figure out how he owes Larry the Loanshark so much damn money. After all, it was only a couple of friendly wagers.
"30 grand!" screams Gary. "How is that possible! It just started with a $1000 bet only a month ago. Please come on, give me another week, please Larry! I'm good for it, I promise. How did it get this high anyway."
"Why compound interest of course, Gary. I told you, I charge 25 points (a term for 25% in the underground business world) a week whenever you don't pay. It's not something I enjoy doing Gary, but it needs to be done."
Here's how it came to be:
-Week 1. Gary the Gambler bets $1000 on the Indianpolis Colts. They fail to cover the spread. Gary doesn't pay up. Now, Gary owes the $1000 plus 25% of that to Larry the Loanshark or $1250.
-Week 2. Gary thinks to himself, "I can make this up quick," and puts $2000 on the Cincinnatti Bengals. They fail to cover the spread. Gary doesn't pay up. Now, Gary owes the $1250 from last week plus the $2000 from this week, totaling $3250. Now add on the 25% compound interest and Gary owes $4062.50.
-Week 3. Gary thinks he can make it back again. He bets $5000 on the New England Patriots. They fail to cover the spread. Gary doesn't pay. Now Gary owes another $5000, totaling $9062.50. Add the 25% compound interest and Gary now owes $11,328.13.
-Week 4. Gary, once again, tries to make up for lost ground. He bets another $5000 on the Denver Broncos. They fail to cover the spread. Gary doesn't pay. Now Gary owes a total of $16,328.13 before adding the compound interest. Once added, Gary now owes $20,410.16.
-Week 5. Gary is getting desperate. He puts $10,000 on the Buffalo Bills. "A sure thing," Gary tells himself. "After all, the Bills are undeafted and the Cardinals haven't won anything in years. The Cardinals win 41-17. This brings us to today, as Gary now owes $30,410.16. If he chooses not to pay, Gary the Gambler will owe another $7,602.54 in interest for next week.
Larry the Loanshark is growing impatient and demands some money. Gary the Gambler tries to explain that he could not get a 3rd mortgage on his home because of the sub-prime crisis, couples with a deflating economy. Larry doesn't care and Gary has to sell his car and boat to make payment.
If only someone had explained to Gary the dangers of gambling and the concept of compound interest.
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