Here's a math problem. How can you turn 1 penny into $5 million dollars in 30 days? It's rather easy.
The answer is simple and can tell you a how most fire departments waste money when they finance their new fire truck.
First, let's turn that penny into a cool 5 mil.
I'll give you 1 penny the first day, the next day I'll give you 2 pennies, the third day I'll give you 4 pennies. I'll continue to double the previous day's gift each day for 30 days.
On day 30, I'll give you $5,368,709.12!
So, will you take that deal? (P.S., send me an email to email@example.com and I'll send you the math so you can double check).
You probably would like that deal.
You are benefiting from a principle called compounding. Each day, your number increases based on the previous day's number. As we see from our 1 penny to $5 million example, it can lead to some dramatic calculations.
So how does this cost fire departments a lot of money?
Bankers play a reverse game of this when they loan you money. Instead of starting small and increasing each day, they give you a large amount of money upfront and start compounding interest until you pay off your new truck.
So, instead of starting small (the 2nd day, you only get 2 cents above), the bank charges a large amount of interest at the beginning. It does get smaller but you spend a lot upfront.
How does my fire department not get caught?
Well, the biggest cost of compounding is time.
In our penny to $5 million example, on day 15 (halfway) , I would only pay you $163.84. Not bad, but a far cry from $5 million.
When you borrow money, the reverse is true. If you borrow for a shorter amount of time, you'll pay dramatically less interest.
The key is to find the balance (as I mentioned in last week's column) of an affordable payment and paying the least amount of interest.
John R. Hill
Apparatus Budgeting Consultant