Compounding or Compounding Interest is a process where your money earns money on its own over time. This is compounding and it’s a powerful process for investors.
Over time, small amounts of money can grow into a substantial amount of money through the process of compounding. Compounding includes the reinvestment of what your money has earned. So as your money “makes” money, that earned money is reinvested and continues to grow. When the process repeats for a long period time, your money grows automatically.
Let’s take an example. For this example we’ll say we have $10,000.00 invested in something. That something earns 10% in one year so your $10,000.00 after one year is worth $11,000.00. Our money, $10,000.00 made $1,000.00 over the course of one year all by itself. You can calculate this by taking 10,000 times .10 which equals 1,000. You add the 1,000 to 10,000 and you’ll come up with 11,000.
$10,000.00 x 0.10 = $1,000.00.
0.10 is ten percent and is also notated as 10%.
Now let’s look at those two parts of our investment as Principal and Interest. Our principal was $10,000.00 when we first started and our interest is $1,000.00. That is, the interest earned. But guess what? After one year of earning 10% interest, our interest is now added to our principal. So in the second year our $10,000.00 is $11,000.00. In the second year our $11,000.00 is the principal that will make money. That’s called compounding or compounding interest.
Like I mentioned earlier, the money that was made is reinvested to make more money. So the money we made, $1,000.00 is added or reinvested to make more money, in this case, $11,000.00.
Are you with me? Good. Read through it again if you don’t understand this concept of compounding.
Let’s keep going. Let’s say our new amount of money to invest is $11,000.00 for the second year and as luck would have it our money earns another 10% in the second year. So does that mean we make another $1,000.00 the second year? No. Because of compounding (also known as compounding interest) we make the 10% on our $11,000.00 which is $1,100.00.
So now we add the newly earned $1,100.00 (interest earned) to our $11,000.00 (also know has our principal) and we have a grand total of $12,100.00 after the second year of earning interest on our initial investment of $10,000.00.
To drive the concept of compounding home, play with some numbers using this Financial Calculator.