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Investing 101: Compounding/compound interest explained

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Compounding is one of the first things they teach you in Investing 101. It is a standard concept in finance, economics and investment theory.

Compound interest arises when you start earning interest on your original investment as well as on interest that you earned in previous years or months.
 
►Here is how it works:
 
Suppose Jack invests $1000 in a bank account paying 10% interest for three years. Jack does not make any additional deposits during this period. His investment will grow as follows:
 
Scenario 1: Jack does not withdraw the interest
 
Year
Start value
Interest
End value
1
$1000
$100
$1100
2
$1100
$110
$1210
3
$1210
$121
$1331
 
 
Scenario 2: Jack withdraws the interest every year
 
Year
Start value
Interest withdrawal
End value
1
$1000
$100
$1000
2
$1000
$100
$1000
3
$1000
$100
$1000
 
 
In year 1, the investment earns $100 interest. By reinvesting the interest (Scenario 1), Jack will have $1100 in his bank account.
 
At the end of year 2, his investment will be worth $1210. Rather than earning $100 like in year 1, the investment earns an additional $10 because the $100 interest gained in year 1 will also grow by 10%.
 
In year three, the account gains $11 interest on the $110 interest earned in year 2.    
 
By withdrawing the interest every year (Scenario 2), Jack will not benefit from compounding or interest on interest earnings.
 
►Compounding only works if you reinvest your earnings.
 
This brings us to another important point:
 
►Compound interest has a greater effect over the long term.
 
Let’s assume that Jack (who is 50 years old) invested his money at age 30. His twin brother (Jackie) only started investing at age 35. Like Jack, he also invested $1000 at 10% interest.
 
What do their respective bank balances show at age 50?
 
Jack’s balance:                    $6727
Jackie’s balance:                 $4177
Difference:                          $2550
 
Both brothers invested the same amount at identical interest rates. But by leaving his account to grow for a longer period of time, Jack managed to gain an extra $2550.
 
The longer you leave your investment, the greater the compounding/ compound interest effect.
 
This is why the experts encourage you to start saving/investing as early as possible. 
 
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roberto@waytowealth.co.za
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