The Beginner’s Guide to Investing: Compounding

Erica HIll

Compounding, also known as compound interest, is the process of taking what you earn from an investment and reinvesting that money back into the investment, earning you exponentially more money as time passes.

For example, if you invest $5,000 and have an interest rate of 4% each year, you will end up with $5,200 ($5,000 x 1.04) at end of year one. Instead of taking that $200 at the end of the year and using it for something else, you would reinvest that $200 with the addition of your original investment, or principal, being $5,000. So, by end of year two, you would end up with $5,408 ($5,200 x 1.04). See how this can grow exponentially? Compounding interest is a gold mine for those who invest in it.

As you can see, the interest you earned the first year was $200. The interest you earned the second year was $208. You didn’t have to do anything additional to earn that extra $8.00. By the end of the next year, you would result in $5,624.32, leaving you with an earning of $216.32. That $16.32 more than the interest you earned in year one and $8.32 more than you earned in year two.

The principal is the initial amount of money you choose to invest. Let’s say you choose to invest $10,000 now and you plan to reap the rewards 50 years from now. Each month, let’s say you choose to add $200 to the principal as you earn more money, and your annual compound interest rate is 5%. Your investment would be worth $617,109.19 at the end of 50 years!

Erica Hill

Visit Investor.gov for a compound interest calculator.

Now let’s say you invested the same amount of money with the same, annual compound interest rate but only invested it for forty years. You would only have $360,319.35 by the end of the term! That is $256,789.84 less!

Erica Hill

Visit Investor.gov for a compound interest calculator.

As you can see, the concept of compounding makes a massive difference in the amount of money you earn on an investment. In taking the first steps towards investing, it is important to not only notice the compound interest rate, but also to decide on a lengthy amount of time to allow your principal and interest to compound.

Interested in learning more about investing? Come back in a few weeks to see more of “A Beginner’s Guide to Investing.” In the meantime, follow me on Twitter for wealth management updates, news, and trends @EricaHill_KW!