The Magic of Compounding

Or what Albert Einstein called the 8th Wonder of the World!

I often get questions like, “Why should I invest in anything? Why not just leave my money under my mattress?” Aside from the obvious – your house could catch on fire and your life savings would go up in smoke, the true answer is that you’re missing out on the compounding that an investment offers.

Let’s start with – what is compounding?

Compounding, in finance, refers to the process in which an asset’s earnings, from either capital gains or interest, are reinvested over time to generate additional growth. Or basically – it’s interest on interest. So instead of just your principal earning money (linear growth), your principal and the accumulated interest on your principal earns money.

Let’s simplify; suppose $10,000 is held in an account that pays 5% interest annually. After the first year, or compounding period, the total in the account has risen to $10,500, a simple reflection of $500 in interest being added to the $10,000 principal. In year two, the account realizes 5% growth on both the original principal and the $500 of first-year interest, resulting in a second-year gain of $525 and a balance of $11,025. After 10 years, assuming no withdrawals and a steady 5% interest rate, the account would grow to $16,288.95.
Compound interest works on both assets and liabilities. While compounding boosts the value of an asset more rapidly, it can also increase the amount of money owed on a loan, as interest accumulates on the unpaid principal and previous interest charges.

Compounding can also work against consumers who have loans that carry very high interest rates, such as credit card debt. A credit card balance of $20,000 carried at an interest rate of 20% (compounded monthly) would result in total compound interest of $4,388 over one year or about $365 per month.