What is Compounding Interest? And Why You Must Know About It?
Interest is the central tenet of the modern financial and economic system. It will not be wrong to say that the modern financial system is based upon interest. However, before we proceed, for simplicity whenever we will refer to interest in this article we’ll mean interest on deposit unless otherwise stated. This disclaimer is needed because interest in itself is a very broad term and it can take many different meanings based on the context it is used.
1. What is Compounding Interest?
“Compound interest (or compounding interest) is interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan. Thought to have originated in 17th century Italy, compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.” (Investopedia)
Compounding interest is a very basic topic that is taught in schools, yet a lot of people forget the importance of compounding. Compounding simply means that if you reinvest your profit returns into your deposit account then you can compound your returns.
For example, suppose you had $100 to start with and with 10% interest you got $10 interest at the year-end. If you do not reinvest this interest then the next year you`ll also get the interest of $10 and so on as long as you do not reinvest your interest. This is called simple interest, that is applied on the principal amount.
Compound interest is different. If you had $100 to start with and you reinvested the annual interest of $10 then in the second year, the interest rate will be calculated on $110 instead of $100, this means that in the second year your interest will be $11 instead of $10.
This is how compounding works and if you leave it to compound year on year and also keep increasing your deposits by investing your savings then your savings will at one point, enter exponential growth phase and your wealth will begin to multiply.
2. How To Make Compounding Work?
Compounding without exaggerating is the secret of millionaires. Compounding is how all the super-rich is able to keep on multiplying their wealth. The super-rich, however, is not likely to be reading this article. So if you are reading this then you are most probably from the middle class struggling to make ends meet. This is how the majority of people live and we hope to achieve financial stability in our lives.
Well, in order to turn this hope into reality we need to follow sound financial strategies and one such strategy includes investing and reinvesting your savings. Now compounding can work for both your investment in certificates and shares. But you may need to follow a different approach for each of your investment options. For instance
- If you deposit your savings in a bank account then you do not have to do anything. The monthly interest will automatically become a part of the principal if you do not withdraw it. You simply have to keep investing your savings without withdrawing them in order to make your savings grow exponentially in a rather short amount of time.
- If you have got term deposit certificates that carry interest then the same approach applies. Your interest will compound if you do not withdraw it unless otherwise stated in terms and conditions.
- If you have shares in your portfolio then you can take advantage of compounding by investing in DRIP stocks. DRIP stocks are dividend reinvestment plans, where instead of annual dividends you are given an equivalent amount of shares for your dividends and therefore overtime your shareholding will increase and thus attract higher dividends.
3. Save And Reinvest
Once you have got savings you must invest them into profitable investment options. If you do not have the required level of financial literacy then it is advisable to use the services of a financial advisor who can guide you.
Identify some safe and profitable investment options and invest your savings. It is better to diversify your portfolio so that in case of any crisis all of your investment doesn’t get hit.
Investment, however, is only one half of the exercise. In order to reap the real benefits of compounding, you must reinvest the returns, profits and/or dividends that you get. Yes, you must reinvest all the returns that you get in order to get the maximum impact of interest compounding. Try to make a habit to reinvest as much as you can and within a short span of time you will see that your savings will start to compound and show signs of exponential growth.
Compounding is a basic mathematical concept that most of us understand but when it comes to the real-world application of compounding we somehow miss out on how we can use compounding to increase our own savings. Hopefully, this guide would have cleared up the concepts on compounding.
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