Compounding gets thrown around a lot when people talk about building a good financial foundation and a roadmap for prioritizing financial goals. And often, the people using the word just assume that whoever they’re talking to will know what it means.
Except that not everyone can casually rattle off the definition of “compounding,” because let’s face it: High school didn’t teach most of us about real-life money management. (So not our fault, btw —it’s just a hard money truth.)
Instead of letting the past hold us back from improving our money mindset now, let’s dive into what compounding means and the ASAP steps you can take to start feeling its potential benefits.
So … what is compounding?
Compounding is what happens when you earn returns (or interest) on not just your original investment, but also on accumulated returns (or interest) you receive over time. Compound interest is generally associated with percentage increases while simple interest is associated with fixed amount increases. Compounding, unlike simple interest, has the potential to supercharge your money, especially over longer time periods. But there’s one caveat: the returns or interest you receive needs to be reinvested and not withdrawn or spent. As you’ll learn in the example below, compounding is a powerful mechanism that works regardless of how much money you start with. Time is what amplifies the impact of compounding; the more time you save and invest, the greater its impact.
What’s an example of how compounding works?
To demonstrate the phenomenon of compounding, let’s use a simple example that compares simple versus compound interest. Say you have $100 in a savings account at your bank. The bank promises to pay you simple interest of 5% per year. That means you’ll receive $100 x 5% or $5 of interest each year.
Starting balance: $100
Year 1: interest: $5, account balance: $105
Year 2: interest: $5, account balance: $110
Year 3: interest: $5, account balance: $115
Year 4: interest: $5, account balance: $120
Year 5: interest: $5, account balance: $125
etc.
Total interest received after 10 years: $50, account balance: $150
Total interest received after 20 years: $100, account balance: $200
Total interest received after 30 years: $150, account balance: $250
Pretty straightforward, right?
Now with compounding, or compound interest, as long as you don't withdraw any money from your account, you’ll earn 10% of the amount that’s accumulated in your account balance, not just the 10% on the original $100 you deposited. This is often called earning “interest on interest.”
Starting balance: $100
Year 1: interest: $5, account balance: $105
Year 2: interest: $105 x 10% = $5.25, account balance: $110.25
Year 3: interest: $110.25 x 10% = $5.51, account balance: $115.76
Year 4: interest: $115.76 x 10% = $5.79, account balance: $121.55
Year 5: interest: $121.55 x 10% = $6.08, account balance: $127.63
etc.
Total interest received after 10 years: $62.89, account balance: $162.89
Total interest received after 20 years: $163.33, account balance: $265.33
Total interest received after 30 years: $432.19, account balance: $432.19
For the first few years, the differences between simple and compound interest are small. However, the longer you allow compounding to work, the greater the impact. After 10 years, you’d have 8.6% more money; after 20 years, 32.7% more; and after 30 years, nearly 73% more.
That’s how compounding works: by earning interest on interest, your money accumulates much faster than with simple interest.
How do you make money by compounding?
There are two main ways compounding comes into play when it comes to money: compound interest and compound returns.
Compound interest
The example above illustrates compound interest. Note that not all compound-interest-earning accounts are created equal. While some compound annually at a low-low percentage (most big banks offer close to 0.42%), others compound more frequently and at moderately higher rates. Since the Federal Reserve began raising rates, many savings accounts now offer interest rates of 4% and higher. More frequent compounding (ie monthly versus annually) means more interest for you, so it’s worth asking your financial advisor if there are higher-interest accounts you should consider.
Compounding can work against you, too — like when you owe compound interest on debt. For example, if the annual interest rate on your credit card is about 18%, then the amount of debt you owe will increase by 18% every year. (That’s why we recommend that you pay off high interest rate credit card debt as fast as you can.)
Compound returns
Compound returns usually come up when we talk about investing. In this case, you aren’t earning interest, which is a promised, steady amount. You’re potentially earning investing returns, which are definitely not guaranteed and definitely not steady. But they can be super powerful, especially if you invest over the long term.
When the value of the individual investments you own — stocks and bonds — goes up (or down), that makes the balance in your investment account go up (or down). As long as you leave the difference invested, then your returns have the opportunity to compound over time. All you need to do is have faith in the “waiting."
If the markets were to go up for a big chunk of the time you had money invested, compounding would work in your favor. And yes, that goes the other way too if the markets decline — that’s why we say that investing comes with risk. BUT. The longer you let compounding work, the more likely you are to have overall positive returns (at least, that’s been the case historically). Case in point: Stocks are typically the riskiest part of an investment portfolio, and they’ve gone up in about 75% of years since 1928 — in fact, the stock market’s average annual return has been about 9.5%.
That’s why investing can be more useful than simply saving as you work toward your money goals and build wealth. Investing allows you to take advantage of the market’s potential for growth.
We like to say investing for retirement is self-care for future you, because the higher your account’s balance and the longer your money’s invested, the more opportunity it has to compound over time (and make your retirement a whole lot dreamier). So getting your money started compounding ASAP is a big deal.
Every day you wait is a day you miss out on the opportunity to start compounding. We’re talking about real money here — by our calculation, it could be about $100 a day. That’s like giving yourself a pay cut of over $17 an hour. Or losing nearly $3,000 a month.*
Yup, the sense of urgency is real. But don’t get discouraged if this isn’t a money move you’ve made yet. It’s never, ever too late to start taking advantage of compounding. And really, that’s all we can do.
Our team of financial planners is here to help you maximize the power of compounding for your financial goals. Learn more about the benefits of joining Ellevest.
Disclosures
*Source: Ellevest. To calculate “about $100,” we compared the wealth outcomes for a woman who begins investing at age 30 with one who began investing at age 40 after having saved in a bank for 10 years. Both women begin with an $85,000 salary at age 30 (both salaries were projected using a women-specific salary curve from Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc., which includes the impact of inflation). We assume savings of 20% of salary each year. The bank savings account assumes an average annual yield of 1% and a 22% tax rate on the interest earned, with no account fees. The investment account assumes an investment with Ellevest using a low-cost diversified portfolio of ETFs beginning at 91% equity and gradually becoming more conservative during the last 20 years, settling at 56% equity by the end of the 50-year horizon. These results are determined using a Monte Carlo simulation — a forward-looking, computer-based calculation in which we run portfolios and savings rates through hundreds of different economic scenarios to determine a range of possible outcomes. The results reflect a 70% likelihood of achieving the amounts shown or better, and include the impact of Ellevest fees, inflation, and taxes on interest, dividends, and realized capital gains. We divided the calculated cost of waiting 10 years to invest, $341,181, by 3,650 (the number of days in 10 years). The resulting cost per day is about $93.47. Dividing that result by 24 hours results in $3.89 per hour.
To translate that result into pay rates, we assume a 30-day month, resulting in a cost per month of $2,843. We then assume the average number of hours worked per month is 160 (40 hours per week multiplied by 4 weeks), resulting in an hourly cost of $17.77.
The results presented are hypothetical, and do not reflect actual investment results, the performance of any Ellevest product, or any account of any Ellevest client, which may vary materially from the results portrayed for various reasons.
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All opinions and views expressed by Ellevest are current as of the date of this writing, are for informational purposes only, and do not constitute or imply an endorsem*nt of any third party’s products or services.
Information was obtained from third-party sources, which we believe to be reliable but are not guaranteed for accuracy or completeness.
The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities, and should not be considered specific legal, investment, or tax advice.
The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person.
Investing entails risk, including the possible loss of principal, and past performance is not predictive of future results.
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