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Compounding Interest Is Powerful, Not Magic

Posted By Jim On 05/09/2011 @ 2:21 pm In Personal Finance | 10 Comments

Compounding interest is great and I love it when personal finance experts point to it as one of the reasons why you should start saving and investing early.

What I don’t love is when experts make it seem like some sort of magical spell.

Compounding isn’t a complicated idea, but it could use some more explaining, and it’s also not perfect. Compounding works great when your money is growing, it’s less good when you’re losing money. If instead of earning 1% in interest each year, what if you lost 1% in interest each year? You’d lose less and less each year, but you’re still losing money!

So, let’s take a closer look at compounding for what it really is.

How Compounding Works

If you don’t understand how compounding works, don’t feel bad. Everyone had to learn 1 + 1 = 2 at some point in their lives and anyone who doesn’t know that shouldn’t be embarrassed. Their parents or their teachers should be embarrassed! (you can’t fault a two year old for messing up, they don’t know any better)

Compounding is simple. If you put your money in a savings account and it earns 10% each year, you understand that $100 will be worth $110 in a year. Easy.

Compounding is what happens when you leave your money in the account and it earns another 10% – this time on a larger sum. Ten percent of $110 is eleven dollars. You earn more because you have more in there. You have more in there because of the interest you earned last year. If you leave it in there for ten years, you end up around $260 because of compounding interest.

Compounding Relies on Time & Rates

Since compounding is really interest earned on interest, time is your biggest friend when it comes to compounding interest. This is especially true when the interest rate is fixed, like on a certificate of deposit, because it’s more reliable.

So the next time someone says compounding interest is the key to your financial future, just know that it’s good but it’s not magic.


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