The Compounding Effect
Albert Einstein has referred “Compound Interest” as The Most Powerful Force in The Universe. So, you can imagine that it should be similar to some super power otherwise he would have not said this about Compound interest. If we understand the reason why he emphasized so much on the significance of the compounding then our perspective towards money and investment will change completely. So, get ready to understand The Power of Compounding.
Compounding is the very fundamental of a financial journey and the sooner you understand it and start practicing it the faster you can become financially independent.
Defining Compound Interest
In simple mathematical terms, compound interest refers to an interest calculated on both the principal amount and the accumulated interest of the initial investment. It helps to grow our money exponentially by reinvesting the interest we earn on our initial savings amount so that we can earn interest on initial investment plus the interest earned.
The Formula
We studied about calculating compound interest in our math class in school I think middle school.
Do you remember the below formula?
| A = P (1 + r/n)^(nt) |
Where:
| A is the total amount (including principal and interest) at the end of the time period P is the principal amount (the initial amount invested or borrowed) r is the annual interest rate (as a decimal) n is the number of times the interest is compounded per year t is the time period (in years) |
If you remember it then congratulations you will get the concept faster than others. However, if you don’t remember the above formula it’s also ok, as I am here to refresh your memory. We often overlook this very important aspect of investing when we think about planning our financial future. We talk about trading stocks, Forex, ETFs, Cryptos, Gold, or buying GICs, whole life insurance policies, savings account and so on but very rarely we talk about the power behind the compound interest.
I strongly suggest if you are in your 20s, or have recently started your job you should understand the concept of how powerful compounding is and you should start using it to design your financial future to become financially free a lot earlier than majority of the population. If you are in your 30s it’s still not late, if you have kids who are in school you can start using compounding for them and give them a financially secure future.
Compound Interest Calculator 
Below is a Compound Interest Calculator, I would strongly suggest to use this to find out how much your money can worth if you put your money in an option where you can get a compound interest instead of a simple interest:
For novice
For my readers who are very new to the concept, I will break it down further to make it clear.
Understand the below terms first:
Principal amount: It’s the initial investment that you make.
Interest Rate or Rate of return: Its’ a compensation you receive for keeping your money invested. It’s calculated a percent on your investment.
Compound Frequency: It refers to how often the interest earned is added to the principal amount, say monthly, or annually etc.
Years or Year of Growth/ investment: It’s the number of years you want to keep your money invested and compounded.
Illustration
Now, imagine this, you have $10,000 that you want to invest (we will call this “Principal”), and you will earn an interest of 5% on it every year. You decide to keep it invested for 5 years. At this point you can have two options: 1. Earn a Simple Interest @5% per year or 2. Re-invest that 5% interest that you earn every year and continue to do so for 5 years.
Option1: Simple Interest – If you had decided to invest your $10,000 for 5 years at 5% simple interest. Then you would get the below interest after 5 years:
Principal X Rate% X Number of years
$10,000 X 5% X 5 = $2,500 as interest.
So, it means a total of your investment plus interest = $12,500.00
{i.e. Principal $10,000 + Interest $2,500}
Option 2: Compound Interest – Now, let’s see the power of Compounding, where we will get 5% interest every year and will reinvest that. Please see below table:
| Year 1 | Investment in Year 1 | $10,000 |
| Interes earned at the end of 1st year | $500 | |
| Year 2 | Amount invested in Year 2 (initial investment + the interest earned at the end of year 1) | $10,500 |
| Interest earned at the end of 2nd year | $525.00 | |
| Year 3 | Amount invested in year 3 ($1050 + $52.50) | $11,025.00 |
| Interest earned at the end of 3rd year | $551.25 | |
| Year 4 | Amount invest in year 4 ($1102.50 + $55.13) | $11,576.25 |
| Interest earned at the end of 4th year | $578.81 | |
| Year 5 | Amount invested in year 5 | $12,155.06 |
| Interest earned at the end of 5th year | $607.75 | |
| Total Interest earned | $2,763 | |
| Principal amount | $10,000 | |
| Total returns after 5 years | $12,763 |
We can clearly see we end up earning $263 extra if we reinvest the interest every year.
Now, use the above calculator and you will find:
- If you reinvest the interest semi-annually you would monthly you will get $12,800 more than simple interest.
- If you reinvest the interest monthly you would get $12,833
I hope you now understand the basics of Compound Interest and how it can impact your Financial Journey!
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