Compounding, the magical power through which we can make our money grow passively, is so incredibly important when it comes to investing that it amazes me how many people aren’t taking advantage of it as soon as possible.
Essentially, you invest some money and watch it grow as the interest compounds over time. Speaking plainly, imagine you have $1 and you invest it. Given enough time, with no further contributions, $1 becomes $2, and then with more time, $4, then $8, $16, $32, $64, $128, $256, $512. Just from that initial contribution of $1! It’s an amazing concept and a key contributor to building wealth.
Making Compounding Work for You
Going into further detail, compounding is a process through which interest is earned on the principal amount deposited AND on the capital gains and interest earned. (You’re making interest on the interest!!!) Over time this can lead to exponential growth. Take a look at the chart below which assumes:
- Initial investment of $10,000.
- Monthly contribution of $200 for 20 years.
- Fixed interest rate of 7%.
- Interest compounded annually.
Using these parameters we can enter them into the compound interest calculator at investor.gov and receive:
This is an increase of 131%. Even if you can only afford to invest $100 initially, and add $100 every month after for 20 years, you can see the growth:
Here we get an equally impressive increase of 106%. It’s amazing to consider how much wealth can be generated through time, patience, and perseverance. The more you can contribute, the faster your wealth can compound. Take a look at the next chart for a couple working towards FI. We’ll assume:
- Yearly income of $120,000 split equally between the two couples BUT they only live off one and invest the other.
- They start young and only invest $1,000 initially.
- Since they have $60,000 to invest annually, they split it equally into 12 monthly contributions of $5,000.
- They do this for 10 years with a fixed annual rate of return of 7%.
- Interest is compounded annually.
This time the increase is only 38.26% but the wealth accumulated is remarkable for a 10 year span. Depending on their withdrawal rate at retirement, they could probably stop soon and live off a percentage below their annual rate of return (but that’s a topic for another time).
What if they don’t stop and they keep going for another 10?
Now that’s exponential growth with a 105.13% overall increase. After 20 years (or well before) the couple can easily afford to retire.
Excited about the implications yet?
Foregoing That Cup of Coffee
One way to maximize as early as possible is by curbing expenses. Imagine a scenario where you spend $80 on coffee every month stopping by Starbucks every day before work.
- Initial investment of $80 (you went an entire month without coffee).
- You continue to not buy coffee and contribute $80/month to your investment for 10 years.
- The interest rate will stay fixed at 6% and compound annually.
Here we see that if you keep the money as cash, the money saved would only be worth $9,680 after 10 years (or $0 if you bought coffee the entire time). However, through compound interest at a fixed rate of 6%, it would be worth $12,796.83. That’s a significant 32% increase.
Using the Rule of 72
This is an easy way to estimate how many years it will take for an investment to double (with no further contributions), provided the annual interest rate stays fixed. To compute for it, divide 72 by the annual rate of return.
An easy way of thinking about this is if you have an annual rate of return yielding 10%, it will take 7.2 years for your investment to double (72/10). So if you start with $1000, it should take roughly 7.2 years for the value to double to $2000. This isn’t exact but it’s fairly accurate for a quick calculation.
How Compounding Will Make You Rich
Hopefully by now you see how important compounding is for accruing wealth. If you can’t already tell, I love it. In order for compounding to be most effective though, you need to invest however much you can, as often as you can, as early as you can. Through using compounding as a tool, you can retire earlier and do what makes you happier sooner.
If you have any questions, please ask below!
I am not a Financial Advisor. Before doing any investing, consult with a licensed professional and/or do your own investigative work. Furthermore, in most investing situations, the interest rate will not stay fixed so the examples provided in this article are for conceptual demonstrations alone. (As are the arbitrary percentages chosen as interest rates since investment returns vary.)