The Magic of Compounding Interest

The world of investments can be incredibly confusing. With all the complex terms and bizarre jargon that are constantly thrown around, it can get a little intimidating to dip our toes into unknown waters. But investments need not be confusing as they are meant to be utilized

A topic that pops up a lot nowadays is the concept of compounding interest. It tends to be spoken about like it is magical in some way, with throngs of financial bloggers and gurus claiming that compounding interests is the holy grail in any investment. But will it?

So what is compounding interest really? And why does everyone seem to be obsessed about it?

Simplifying Compounding Interest

Compounding Interest is the idea of “interest that builds upon interest”. It happens when you earn interest on money that you had previously earned also as interest. It is a term akin to the snowball effect, which refers to how something can get bigger and bigger over time as it continues to build upon itself. Except, instead of a snowball rolling down a hill, it isn’t snow. It’s money. And it’s not a hill, it’s time.

So if you are keeping money in a bank account that is continuously compounding interest, you would be earning a substantial amount more than you would if you were just earning a simple interest on top of your initial deposit. 

Here’s an example to better demonstrate this concept:

Let’s say you deposit $100 in an account that earns you 10% interest every year. (Yes, 10% is far fetch for most investment returns, but we’ll use this figure for easy calculation).

  • At the end of the 1st year, you’d have $110 ($100 + $10 interest earned)
  • At the end of the 2nd year, you’d have $121 ($110 + $11 interest earned)
  • At the end of the 3rd year, you’d have $133 ($121 + $12 interest earned)
  • At the end of the 4th year, you’d have $146 ($133 + $13 interest earned)

Compounding interest is at work here, since it is both your original deposit amount and your subsequent interest earnings that are generating more interest. Sounds exciting, doesn’t it?

Let’s see what the difference would be if you were to only earn a simple interest on a deposit of $100:

  • At the end of the 1st year, you’d have $110 ($100 + $10 interest earned)
  • At the end of the 2nd year, you’d have $120 ($110 + $10 interest earned)
  • At the end of the 3rd year, you’d have $130 ($120 + $10 interest earned)
  • At the end of the 4th year, you’d have $140 ($130 + $10 interest earned)

In this example, after four years of compounding interest, your initial deposit of $100 is now worth 46% more. Without compounding interest, it would only have been worth 40% more.

Now, the amount you’d make with $100 invested in just four years may not seem like much. But once you start putting in money by the thousands and let it grow for years, that’s when you’ll see the true magic of compound interest at work.

And the best part about it is that you don’t even have to do anything!

How To Take Advantage of Compounding Interest

The best way to see the effects of compounding interest is to invest early and as often as you can. To grow a fortune, you must be patient. And time is going to be your best friend. It will take a while for the money in your account to gain some momentum, but once it does, you’ll be glad you waited.

You can use a calculator like this to help you figure out just how much you’ll gain.

Some discipline will be involved too. You must resist the urge to withdraw any of the money you’ve saved as this will lower the interest you’ll generate.

Remember, compound interest will work like magic only if you allow it to. Be smart about your investments and think long-term.

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  • […] Possessing a keen sense of financial literacy with frugality can greatly help your financial state and grow your wealth when you start to earn more. Focusing your efforts on improving your earning power will help you manage your daily and monthly expenses better as now you won’t feel as constricted and the extra cash you have leftover can be easily placed into investments or savings. Earning more will also help you get out of debt faster. And the faster you pay off your obligations, the more surplus cash you would have, and this in turn can be invested to grow your wealth by leveraging the magic of compounding interest. […]

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