Compounding interest, compounding interest, compounding interest. Say it out loud (or in your head one more time) so you remember it. It is the most essential term to understand in order to take control of your financials. Compounding interest is what puts some people in financial misery and makes other financially independent. Get an understanding of compounding interest early in your life, and be in control!
Compounding interest is in short interest on interest.
An example of this is that the first year $1 is invested with an 10% interest it will yield 10 cents, so that you have $1.10. The second year this investment however has 10 cents more to earn interest than in the first year. The investment will as such yield 11 cents instead of 10 cents in year two, so that you have $1.21 after the second year.
Thus the 1 cent extra in year two is interest on interest.
One cent? Is that it? Yes – and no. In the example above it seems negligible, but compounding interest’s exponential power shows itself more clearly over a longer time period.
Below is a chart of how a single dollar can develop over 20 years earning 10% interest. The chart splits returns up in three: the 1$ initial investment, 10% interest on the $1 and the compounding interest. Here it is clear that the $1 could stay $1 by not investing, become $3 by investing and taking out interest or become $6.73 by earning interest on the interest.
The chart shows what happens with $1, but just think about what it could do for you if you invest $1,000 ($6,727), or 100,000 ($672,750). And if the investment is left for 30 years instead the factor is 17.4x instead of 6.7x!
For the mathematically interested reader the formula for compounding interest is:
Future value = P * ( 1 + i )^n
Where P is the principal investment, i is the the interest and n is the number of compounding periods (often years)
As it is shown in the formula the important components for compounding interest is the interest and the number of compounding periods. As such, you should try to invest where you get the best possible return and start young so you can enjoy the compounding in as many years as possible.
Many know how to calculate compounding interest, but few understand it so well that they live by it and prioritise to make it work for them. We try to think about it in most of our long term financial decisions and with this post we really hope that you will do too.
This post has focused on compounding interest on your investments. The same principles work on interest on debt (just in a negative way), so make sure you think about it when you borrow money.
Compounding interest is an essential part of financial control so if you have any questions about it make sure to ask them in the comments.