by Carter Hodgson
Compound – the ability of a sum of money to grow exponentially over time by the repeated addition of earnings to the principal invested.
You may be thinking this definition is about as helpful as googling “fraud” and getting this definition: the action of committing fraudulent activities. But I promise you that after checking out the example below, you will fully understand and be ready to grasp the immense power of compounding.
First, let’s look at an example using simple interest:
- Assume we have $1,000 to loan out at a 10% interest rate over 5 years
- Then, we would get $1,000 x 10% = $100 of interest each year, resulting in $500 in interest over the 5-year period
- This means that we would make a $500 gain on the loan, which is a fine gain!
However, let’s see how compound interest could give us a greater gain over 5 years:
- Now assume we invest $1,000 into a stock that earns 10% each year for 5 years.
- Year 1 we would get $1,000 x 10% = $100 gain, but here’s where the Magic happens ⇒ Year 2 we get $1,100 x 10% = $110 gain
- Year 3 we get ($1,000+$100+$110) x 10% = $121 gain
- Through Year 5, we end up with $1,611 which is a gain of $611 on our initial $1,000.
So, the second example shows us that we can make greater profits when money builds on itself – resulting in exponential returns vs linear.
Why it Matters:
The chart below shows the difference in savings for someone who starts planning for retirement at age 25 vs 35. The difference is an astounding $563,419! This is because compounding grows exponentially with time, so the last 10 years (age 55-65) produce a large portion of the growth.
- Invest your money EARLY!
- Sit back and let the power of compounding go to work
- Reap the benefits later