Compounding is the snowball effect in investing due to interest earned on interest and has been referred to as “the eighth wonder of the world.”
To illustrate the compounding effect, let’s start with what it is NOT. Assuming a starting balance of $4,800 and $4,800 contributed annually (or $400 per month) in a checking account over 10 years:
Here is what the math looks like:
$4,800 + ($4,800 * 10 years) = $52,800
Here is what linear growth looks like graphically:
However, with compounding or the snowball effect, growth is not linear but rather exponential.
Here is what the math looks like:
Interest = Previous year’s balance * 10%
Current year balance = Previous year’s balance + contributions + interest
Because the interest earned gets reinvested (included in the current year’s balance), the interest earned increases at a faster and faster rate over time (the snowball effect). Notice in year 8, the interest earned starts to outpace the annual contributions!
Here is what exponential growth looks like graphically:
Calculator: https://www.nerdwallet.com/calculator/compound-interest-calculator
With the same $4,800 initial deposit and investing $4,800 annually in the S&P 500 for 10 years with a 10% rate of return, you would still have contributed $52,800 but instead have nearly $89,000, including over $36,000 in interest!
If you know you are leaving money on the table and you’d like to partner to get started with investing, visit MakingMoneyIsSimple.com to book a free consultation.