Compounding essential means earning interest on interest already earned plus your initial capital. It is the fastest way to make a return on any capital you want to invest.
Compounding is the process of generating more return on your money 💸or an asset's reinvested earnings. It is like a snowball effect which continues to accumulate more and more⛄. Compounding works by reinvesting your profits at every opportunity.
Compound interest can help your initial investment grow beyond your wildest expectations 🤑and it is best to start investing at the earliest age when considering compound interest. This is because the longer your investment is compounded the more returns you will gain💎💎. ⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀
Compound interest isn't just an angel, it can also be a devil in disguise. How? Well the same way compound interest can add more to your bottom line by reinvesting your earnings ...it can also add more to your debt by compounding your debt😱. ⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀
This means interest owed on your debt will be added to the debt and more interest will be charged to the combined interest + debt…. This process goes on until you repay you the debt in full. For this reason you must always know the interest structure on the financial products you enter into. This will at least prepare you for any eventuality.
Example of compounding
If you put your £10,000 in a simple interest account for 3 years and the account pays 5% per annum you will receive £500 in interest every year.
At the end of year 3 you will have received £1500 in interest.
If you put the same £10,000 in a savings account which is compounded annually with a 5 % interest then in year one you will earn £500 in interest but in year 2 the interest will be charged on the initial £10,000 plus the £500 earned from year one. So the second year interest will be £525.
In year 3 you will earn interest on the initial capital of £10,000 plus the £500 earned in year one plus the £525 earned in year 2 which will earn you £551.25. In total you would have earned £1576.25 in interest over 3 years by using compound interest in comparison to £1500 from simple interest.
The effect of compounding becomes greater over longer periods as the amount of earned interest increases.
The rule of 72
What is the rule of 72?
The Rule of 72 is an easy way to find out how long it will take to double your money. All you need to do is divide 72 by the interest rate that you expect to earn.
Let’s say you earn an interest rate of 6%
Then 72/6 = 12
So your money doubles in 12 years
Now, how would you do the opposite? You know that you want your money doubled in eight years, but you don’t know what interest rate you need.
72/8 = 9% interest rate