The (almost) magic of compounding
Compound interest has been called one of man's greatest inventions, but we'll settle for calling it a saver's best friend. Here's why.
What is compounding?
Essentially, compounding means that you earn new returns on the gains you've previously made. Here is a hypothetical example just to illustrate the math, rather than a particular type of account or investment:
Let's say you deposit $1,000 in an account (that's your principal). If the account earns 10% interest, you've earned $100 after a year.
So far, so good. Now watch what happens in year #2.
$1,100 year-end balance
year 1 interest
Year 2 interest
You've earned more in year two ($110) without depositing any more money from your pocket! It's not magic, it's just wonderful math. Not sure why it's so great? Take a look at what happens if we let it ride for 20 years.
$1,000 principal + $100 interest
$1,000 principal + $5,272 interest
We showed you the result after 20 years for a good reason: the key to compound interest is time. Check out the difference between compounding for 10 years versus 30 years.
Total after 10 years
Total after 30 years
One more big point: compounding can happen in savings accounts or potentially in investment accounts, but there is a difference. The interest rate on a savings account is typically guaranteed for a certain period, and in the last ten years has hovered in the low-single digits on average.d1
Compound returns can occur in an investment account, but with more risk and volatility than in a savings account, including the potential loss of principal. Of course, with higher risk comes the possibility of higher reward.
How to make compounding work for you
We can't say this enough. Compounding is fantastic, but it needs time to work.
If you withdraw your profits and put them in your pocket, your earnings don't compound. So keep your gains invested and re-invest payments you might receive such as interest on savings and bonds, or dividends from stocks.
Another thing we'd like to point out about our example above is that we did not include any fees or taxes that may apply in a real account, because we wanted to demonstrate the pure mathematical concept of compounding. Most accounts would have some kind of fees that would impact the rate of return, and we all know the old saying about death and taxes. We are also not making any kind of prediction or projection about performance or any particular strategy.
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