Motley Fool Australia

What is Compounding?

Albert Einstein is claimed to have once said “Compound interest is the most powerful force in the universe. Compound interest is the 8th wonder of the world. He who understands it, earns it, he who doesn’t, pays it.”

Considering that Albert Einstein was one smart cookie, let’s take heed in his advice and utilise this power called compounding.

In this article, you’ll understand what compounding is, how you can use this to boost your savings, how to calculate it and what you can do next to turbocharge your wealth.

Understanding compounding

Before we delve into what compounding is, let’s take a look at simple interest.

Simple interest is calculated on the initial principal. For example, if you have $10,000 in the bank and your simple interest rate is 1%, then the interest earned is $100. Very clear and simple to understand.

The growth rate of your bank account is linear and incremental but there’s no exponential growth.

However with compounding interest, your money accumulates a lot faster because the interest is calculated in regular intervals and you earn interest on top of interest. How cool is that?

To understand this further, let’s have a look at the following graph.

Image source: The Motley Fool

As you can see, compound interest far outweighs the results when compared to simple interest. 

Special considerations when calculating compounding interest

In order to calculate compound interest, we need to use the following mathematical formula:

A = Final amount including principal

P = Principal amount

I = Interest rate

n = Number of years invested

When calculating both simple interest and compound interest, the end number is also known as the future value (FV).

You may notice that the future value is different when comparing simple and compound interest. 

A special consideration to take note of, is that the simple interest is calculated on a fixed percentage. For example, if your loan is $10,000 and your simple interest is 10%, then you’ll have $1,000.

However with compounding interest, your future value grows over time because compounding interest factors in your interest gained on top of other interests. 

Increased compounding periods/frequency

The beauty behind compounding is that the interest is calculated on top of your interest and the frequency of deposits.

For example, if you make a deposit every month, your interest will be calculated along with your deposits as well.

The more deposits you make, the faster you accumulate wealth.

Therefore, a good rule of thumb is to make regular and consistent contributions and let the wonderful power of compounding work its magic. Here is an example of how you can increase your savings if you embrace compounding earlier, rather than later.

Let’s say you have three people saving at different points of their lives. One person saves at age 25, another at age 35 and the other at age 40. 

The first two investors save $300 per month whilst the last investor saves $600 per month at age 40 to try and catch up for lost time.

Each investor earns an annual rate of return of 5%. 

If we compare the results of all three investors, we can see how the results vary.

Investor 1 who started saving at age 25 ends up having $460,000.

Investor 2 who started saving at age 35 ends up having $251,000.

Investor 3 who started saving at age 40 ends up having $180,000, despite investing more money. 

Simple vs. compound interest

To compare against simple and compound interest, you can clearly see a major difference.

With simple interest, your interest earned does not compound and it’s calculated on your total balance.

As for compound interest, it’s calculated on the principal amount and then accumulated on the previous periods of deposit, which is earning interest on interest.

Here’s an example of simple interest over the next 5 years.

Year 1

Balance: $10,000 

Interest: $100 

Total: $10,100

Year 2

Balance: $10,100 

Interest: $100 

Total: $10,200

Year 3

Balance: $10,200 

Interest: $100 

Total: $10,300

Year 4

Balance: $10,300 

Interest: $100 

Total: $10,400

Year 5

Balance: $10,400 

Interest: $100 

Total: $10,500

Year 10

Balance: $10,900 

Interest: $100 

Total: $11,000

As with compounding interest, you earn interest on your initial deposit and the interest on top of it.

For example, let’s say that your initial deposit is $10,000 and you make regular monthly deposits of $100.

Here’s how compounding interest plays out over a 10 year period.

Year 1

Initial Deposit: $10,000 

Regular Deposit: $1,200 

Total Interest: $540 

Total: $11,740

Year 2

Initial Deposit: $10,000 

Regular Deposit: $2,400 

Total Interest: $1,168 

Total: $13,568

Year 3

Initial Deposit: $10,000 

Regular Deposit: $3,600 

Total Interest: $1,890 

Total: $15,490

Year 4

Initial Deposit: $10,000 

Regular Deposit: $4,800 

Total Interest: $2,710 

Total: $17,510

Year 5

Initial Deposit: $10,000 

Regular Deposit: $6,000 

Total Interest: $3,634 

Total : $19,634

Year 10

Initial Deposit: $10,000 

Regular Deposit: $12,000 

Total Interest: $9,998 

Total: $31,998

As you can see, over time, your money grows rapidly. Of course, the big lesson here is that the earlier the start, the better. However, even if you start later on in your life, you would still need to save even more money to catch up to early savers.

Why is compounding essential?

Compounding plays a pivotal role in growing your wealth. As you can see, if you decide to keep your money in the mattress, it won’t grow at all. If you decide to keep your money in the bank and let it grow with simple interest, it will take quite a long time for it to double.

I’m not sure about you, but I don’t have 72 years to double my money to live life like a rockstar.

So what else can we do? We use the compounding interest method. The results will be small at the start but over time, your wealth will accumulate fast.

Warren Buffet is known to make his wealth later in his adult life and this is due to the compounding interest effect on his deposit.

Get started with compounding your wealth

If you would like to play around with some numbers and understand the power of compounding, you can do so using this Compound Interest Calculator.

Simply enter in the numbers such as initial principal, monthly contributions, and interest rate, and the calculator will automatically calculate the numbers each year.

Remember: the sooner you get the magic of compounding working for you, the sooner you’ll be able to turbocharge your wealth.