What is compounding?
Albert Einstein once described compound interest as “the eighth wonder of the world”. “He who understands it, earns it; he who doesn’t, pays it.”
Compounding effectively means earning interest on interest. The prerequisite is that you reinvest what you have earned to take advantage of compounding. In the example below you can see that in year 2 you have earned 64 more than in year 1. That is the interest component of the reinvestment (800 x 0.08 = 64).
By continuing the reinvestment strategy you can see that in year 10 you are earning almost double the yearly interest compared to year 1 and this without any additional effort from your side. This is the power of compounding.
Should you choose not to reinvest but rather extract the interest every year you would have earned 10 x 800 = 8000 opposed to 11589 (3589 more by compounding).
The graph below shows the huge impact only 3% interest difference has over a 10 year period when compounding.
