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Investor Education

Power of Compounding

What is compound interest and why is it so important?

What is compound interest?

Compound just means something that comes in two parts.

Interest is the addition of a small amount of money at the end of the year to the money that you had at the start of the year.

Compound interest refers to the additions of a small amount of interest on the interest that you earned in earlier years. In other words, the addition of a small amount of money to the small amount of money you earned the year before.

Why is it so important?

The table below shows what happens to $100 over 1, 5, 10 and 30 years at different interest rates. If we started with $100 and held it for 30 years at 2.0% interest, you would expect $60 of interest, so you’d end up with $160 at the end of the 30 years. But my table shows $181. Where does the extra $21 comes from? The extra $21 comes from the 2% interest that you’d earn on the interest that was earned in the year before, ie. The compound interest. Taken over time, the 2% extra you earn on the 2% interest, taken over 30 years adds up to $21, or 21% of your starting sum!

This effect becomes far more powerful once the interest rate or growth rate becomes higher. At 5.0%, $100 becomes $432 after 30 years. Once we start considering stock investing type returns at the 10 % to 12% levels, compounding leads to $259 and $311 after 10 years, and the large sum of $1745 and $2996 after 30 years.

Conclusion: compounding is a powerful effect.

Effect on $100

Growth Rate2.0%5.0%10.0%12.0%
Years
1102105110112
5110128161176
10122163259311
301814321,7452,996
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