The Compounding Effect

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The compounding effect is something many of us have probably heard of, but don’t have an intuitive understanding of. Compounding is the process where interest is credited to the principal amount as well to interest already paid. Thus you can think of compounding as interest on interest which magnifies returns over time. It is different than linear growth and is more similar to an exponential function.

The compounding effect can be positive or negative. While compounding raises the value of assets faster, it can also increase the amount of money owed on a loan so that even if you are making payments the money owed can be greater in future periods. This concept is especially bad for credit card balances. This is due to the fact that interest rates for credit cards are already high, but on top of that you are paying interest on the interest amount that is high to begin with.

You might wonder what the difference is between compounding and simple interest. Simple interest only pays interest on the principal amount. For example if you put $1000 in a bank account with simple interest you will only get $50 a year. No matter how many years you keep the money in the account assuming interest rate is the same yield amount will be the same.

The rule of 72 is a short hand way to know how long it will take for an investment or savings amount to double in value if there is compound interest. The basic rule 72 divided by the interest rate is the amount of years that it will take to double. If a given example interest rate is 5% it would take around 14 and a half years to double.

In short it is best to find yourself on the asset/wealth creation side of the compounding affect. This way you will get more money faster than just simple returns. However if you take on debt you will be paying a larger balance for longer. With compounding you are dealing with exponents instead of linear equations.

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