5) Investing 101: The Concept Of Compounding

by · August 23, 2010

Compound Interest

Compound interest happens when interest is added to the principal, and the interest itself also earns interest. This addition of the interest to the principal is what is known as compounding. This is the wonder of compounding; it makes your money earn bigger and faster than simple interest normally would.

In finance compounding is the process of generating earnings on an asset’s reinvested earnings. It requires only two things to work: the re-investment of earnings and time. When more time is given to an investment, the more it is able to accelerate the income potential of the original investment.  Over time, compound interest allows for exponential growth.

Let us look at this simple explanation:

If you invest $10,000 today at 6% interest rate, you will have $10,600 ($10,000 x 1.06) in a year’s time. Now let’s say that you don’t withdraw the $600 gained from interest and reinvest it for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236.00 ($10,600 x 1.06) by the end of the second year. Because you reinvested the $600 you earned from the principal, it now works together with the initial investment, and earning you $636 on the the second year. While $36 more may not be a large sum, don’t forget that you didn’t have to do anything to earn this amount. In addition to this, the $36 will also have the capacity to earn interest. If you continue to reinvest the earnings from interest, your investment will now be worth $11,910.16 ($11,236 x 1.06). On the third year you earned $674.16, which is $74.16 more than the first year. This increase in the amount made each year is compounding in action: interest earning interest on interest and so on. It will carry on as long as you keep reinvesting and earning interest.

Starting Early

Let us consider another example:

At the age of 25, Pam made an investment of $15,000 with an interest rate of 5.5%. The interest rate was compounded annually. By the time Pam reaches 50, she will have grown her investment to $57,200.89 ($15,000 x [1.055^25]).

Now take Sam: Sam did not start investing until he reached age 35. At that time, he invested $15,000 at the same interest rate of 5.5% compounded annually. By the time Sam reaches age 50, he will have $33,487.15 ($15,000 x [1.055^15]) from his investment.

So why does Pam have $23,713.74 ($57,200.89 – $33,487.15) more money than Sam even though their investment amount and interest rates were the same? The answer is obvious. Sam invested 10 years earlier than Pam. She gave her money more time to grow. Through it Pam earned a total of $42,200.89 in interest and Sam earned only $18,487.15.

Editor’s Note: For now, we will have to ask you to trust that these calculations are correct. In this tutorial we concentrate on the results of compounding rather than the mathematics behind it. (If you’d like to learn more about how the numbers work, see Understanding The Time Value Of Money.)

You will notice in the graph that the investments start out slow and then accelerate as it ages, increasing exponentially. This is reflected in the increase in the curves’ steepness. Observe how Pam’s line becomes steeper as she nears her 50s. It is not because she has accumulated interest, but because this accumulated interest is itself accruing more interest. If we add another 10 years to the investment, Pam’s line grows even steeper (her rate of return increases). At age 60 her investment would be nearly $100,000, while Sam’s investment would only be around $60,000, a clearly huge difference!

When you invest, keep in mind that compounding amplifies the growth of your working money. Just like investing maximizes your earning potential, compounding maximizes the earning potential of your investments. It is crucial to remember that as compounding needs both time and reinvesting to work as it should, you must make certain not to touch the principal and earned interest.