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In simple words, compounding means reinvesting the income earned from an investment at the same rate of return at which original investment was made, to increase the principal. Compounding was once called Compound Interest, because its appeal comes from the interest your account earns, which is added to your account total and earns more interest. Investing is one way to make sure your money compounds over time. The power of compounding is visible as your money earns interest. The interest increases the total on your account, and that larger total earns more interest. You profit from what mathematicians call exponential returns. When this happens over and over, our savings and investments grow and wealth is accumulated. Interest is determined by the amount we have saved or invested (principal), the rate we earn, and the length of time we can leave the amount invested. Even at today’s low interest rates, compounding makes a big difference over time. A $1,000 savings deposit at 3 percent compounded daily will grow to $2,460 in 30 years. Without compounding, the same deposit will be worth only $1,900 in 30 years. That’s $560 extra. Another important aspect of compounding is the rate difference. Most of the times people tend to ignore small interest rate differences that different investment options offer. However, in conjunction with power of compounding, these small rate differences might make such huge impact, that it might turn out to be hard to believe. The bottom line is that interest rates create incentives for people to perform specific action. Take someone borrowing money for example. That person has an incentive to pay back the amount owed due to the interest rate on the base amount (principal). |
