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Compound Interest Week: The Real Rate of Return

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Yesterday we learned some interesting math about doubling your money. In the end, we played with some unrealistic returns such as 17%-20% interest rates and the astronomical numbers that can result.

Unfortunately, it's not quite as easy as invest, wait, and cash in $300 million dollars. Every year, the price of the things you buy gets more expensive. You've probably heard the story from grandpa saying, "In my day..." He usually finishes it with something about how little a gallon of milk was or how much it cost to mail a letter. We call this phenominom of things costing more money over time, inflation. On average, all the things we buy seem to grow by about 3.10% - if this inflation data from 2004-2007 is accurate.

This means that things are getting are more expensive while you are earning that interest. You need to subtract inflation to get the real rate of return after inflation. This real rate is how much buying power your money has gained - or in some cases lost. For instance, if you keep $100 under your mattress, it will still be $100 in 10 years, but milk and stamps will have risen and you will be able to buy less with it. On the other hand, if you are making 8% in interest, and inflation is 3.10%, you are really gaining 4.9% in buying power.

Posted on May 8, 2007.

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