In the world of finance, there’s a popular saying that goes “the rich get richer”. While this may seem unfair, it’s actually due to the power of compounding. Compounding and compound interest are two of the most important concepts in personal finance, investments, and savings. By understanding what compounding is and how compound interest works, you can use them to your advantage and make your money work harder for you.
What Is Compounding?
Compounding is a financial concept that refers to the process of earning interest on interest. This means that your money can grow over time, even if you don’t add any additional funds. The longer your money is invested, the more it can earn through compounding. The compounding effect is the result of reinvesting earnings back into the investment, resulting in exponential growth.
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How Does Compound Interest Work?
Compound interest is the interest earned on the initial principal amount and on any accumulated interest. It’s interest on top of interest, which allows your money to grow faster than simple interest, which is only calculated on the initial principal amount. The compounding effect means that your money can grow exponentially over time.
To illustrate how compound interest works, let’s look at an example. Let’s say you invest $1,000 in an account that earns 5% interest annually. After one year, your investment will be worth $1,050. However, if you leave that $1,050 in the account for another year, you’ll earn interest not only on your initial $1,000 but also on the $50 of interest earned in the first year. So after two years, your investment will be worth $1,102.50. The longer you leave your money invested, the more it will grow through compound interest.
