There are some things in life that are plain just good to know, compounding is one of them. One of life’s secrets, first pointed out to me as a younger man by a friend of my father’s.
Such a simple concept, but can really make a big difference when fully put into motion.
The Art of Compounding
You have likely been living under a rock if you have not come across the concept of interest. Currently, interest from a Bank is nothing to write home about, but, compounding can still have a great effect on such meagre returns.
Let me explain…
Put simply, interest is an amount of return, measured as a percentage of the ‘principle’. The ‘principle’ is just the amount of money that the interest rate (%) is applied to.
So, let’s say you put $100 into a Bank account which offers a 5% interest rate per year, you would expect the bank to give you $5 (5% of 100) at the end of the year if you leave your money with them.
The concept is simple, and one dimentional.
How does Compounding Work?
Compounding happens when, using the above example, you keep your $100 in the bank, plus the interest earned in the same account for the next year… and thereafter.
When you first look at interest paid, you think that you will be earning $5 per year, each year. But that only happens if you remove the $5 on payment. If you chose to not remove that interest payment, the second year results in a 5% interest rate being applied to $105, not just the simple $100.
Big deal I hear you say, ‘I will earn %5.25 in year two, as opposed to $5’
This is true, but as each year passes, your principle grows and therefore attracts an ever increasing interest payment at the end of it.
So Where is the Magic?
Leaving your interest payment each year in your interest giving Bank account actually results in an exponential growth of that account. No longer is it a simple $5 yearly rate of return, but an increasing interest payment as time goes on.
As your principle each year increases, so does your interest payment, resulting in an ever increasing monetary rate of return.
This is exponential growth, also known as a ‘hockey stick’ graph if you look at it on paper.
At some point in the future, your interest payment will be so big that it dwarves your original $100 original input.
Have a play with the Compounding Calculator below to see the magic happen.
Compound Interest Calculator
1. Starting Lump Sum Saving: (£)
2. Monthly Savings: (£/month)
3. Interest Rate (%):
There was an error with your input. Please try values like:
- Lump Sum = 1000
- Monthy Savings Rate = 10
- Interest Rate = 1.4
- Years = 25
Real Life Applications
Although not directly the same as the interest in a bank account example but conceptually very similar, you will see the concept of compounding in many areas of life.
We are all aware of the dominance of Social Media, as an example. How it has grown from nothing to a behemoth in 20 years. Compounding can be seen in the basic set up of a Social Media platform.
Most companies have to hire Marketing staff to create content for them to attract sales. Social Media companies, on the other hand, hire Marketing Staff to get new users, who then in themselves create further new content, acting as Marketers, which attracts more new users. Exponential content and growth creation.
The concept of Network Marketing works by a similar operation. Recruit recruiters and watch your business explode… If you wanna be that person that is…
Now that you understand the exponential magic of compounding… Put it to work.
Diver, Biker, Cyclist, Vegan, Contrarian, Conspiracy Theorist (alleged), Nerd (confirmed)
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