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Compounding Effect – A Lesson on How Money Makes Money

If only I had learned about the compounding effect of money when I was a teenager. I had heard about the seven wonders of the world, but no one had ever told me about the eighth wonder, the compound effect. It doesn’t matter if you are young or a little older, read on to find out how money can make money.

Compounding earned interest is one of the most critical lessons that should be learned by everyone. To explain the composition effect, I will use a short example. If you take $10,000 and receive 6% interest over one year, you will receive $600. If you reinvest the $10,600 in year two, you will receive $636 interest. In year 3 you will receive $674 in interest and this amount increases each year as long as you reinvest the principal and interest annually.

The next step and even more effective way of using interest compounding is to contribute additional money, for example $100, every month to the capital and interests. This will help you track your wealth faster and has the effect of increasing your amount of capital at a rapid rate.

Instead of the investor earning interest on the principal, they earn interest on the principal and interest, year after year after year.

If you start early in life, this can have a dramatic effect on capital growth over time. If an 18-year-old invests $100 per month and earns 6% interest until age 65, they have accumulated $313,187. They had invested $56,400 during this time, a profit of $256,787. However, if the same person started investing at age 25, he would have accumulated only $199,149. They have invested $48,000 during this time. So by starting 7 years earlier and investing $8,400 more (7 years x $100/month) they have accumulated $114,038 more by age 65.

It is crucial that we teach the compounding effect to everyone in our lives, as it is THE KEY to future financial success for most of us. For a little pain in the short term by putting some money, we can experience a terrible gain in the long term. Do not be tempted to give up the interest earned each year, as this will negate the compounding effect and limit success with this strategy.

One of the best things about the compound interest effect is that it doesn’t discriminate – EVERYONE can do it, it doesn’t matter if you are rich or poor or where you live in the world. The big decision is when to start and I urge you all to start today.

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