What is Compounding?
Compounding is the process by which the earnings of your investments generate earnings.
How Does Compounding Make Money?
Simply put, your earnings, such as interest payments, generate more interest, which in turn generates more. As an example, let’s compare two different investors. They both make a single investment of $1,000 that generates an annual return of 5%. Investor A reinvests the earnings every year while Investor B withdraws the earnings each year but keeps the original investment in place. The table below illustrates the difference between the two investment strategies and the benefits of compounding.
Investor A earned $2.50 more than Investor B simply by reinvesting their earnings. That may not sound like much, but over the long term compounding can be quite powerful.
Time and Compound Interest
Albert Einstein is supposed to have said that compound interest is the “… eighth wonder of the world. He who understands it, earns it… he who doesn’t pays it.” While it is unclear if he actually said that, what is clear is how powerful compounding can be, especially when combined with time. Let’s use the same example above but stretch out the time period to 30 years. In terms of investment earnings, this is what you would get:
Investor A demonstrates the concept of compound interest while Investor B illustrates simple interest. Notice how, with enough time, Investor A’s earnings increase exponentially while Investor B’s earnings remain linear. Investor A ends up with $1,822 more than investor B without having to “work” more. They let their money work for them.
One important thing to keep in mind is that while compound interest can be your friend, it can also be your enemy. It can be your frenemy. Think high-interest credit cards and other consumer debt. Those generate compound interest as well, but not the good kind. So get rid of that debt ASAP because you want compound interest to work for you, not against you.