Albert Einstein said that compound interest is “the greatest mathematical discovery of all time.” We think this is true partly because, unlike the trigonometry or calculus you studied back in high school, compounding can be applied to everyday life.
The wonder of compounding (sometimes called “compound interest”) transforms your working money into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating earnings on an asset’s reinvested earnings. To work, it requires two things: (1) the re-investment of earnings, and (2) time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off of you.
To demonstrate, let’s look at an example: If you invest $10,000 today at 6%, you will have $10,600 in one year ($10,000 x 1.06). Now let’s say that rather than withdraw the $600 gained from interest, you keep it in there for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236.00 ($10,600 x 1.06) by the end of the second year.
Because you re-invested that $600, it works together with the original investment, earning you $636, which is $36 more than the previous year. This little bit extra may seem like peanuts now, but let’s not forget that you didn’t have to lift a finger to earn that $36. More importantly, this $36 also has the capacity to earn interest. After the next year, your investment will be worth $11,910.16 ($11,236 x 1.06).This time you earned $674.16, which is $74.16 more interest than the first year. This increase in the amount made each year is compounding in action: interest earning interest on interest and so on?. It’ll continue as long as you keep re-investing and earning interest.