Back to Basics- What is compounding?

Updated 8 months ago

Sometimes we use terms that must seem like lingo, unknown terminology, to folks who may not understand what is meant. We want everyone to feel included in this conversation so we will have back-to-basic sessions once in a while to explain concepts.

Compounding is another way of explaining compound interest. That is the effect of an asset, let’s say money, earning interest. Then that interest and original money becoming a pile that ALSO earns interest. Then the interest getting added to THAT pile and all of THAT earning interest. And so on and so forth.

Simple interest would only be earned from the original, or principal, amount. Compound interest is earned from the principal and from the interest.

An example would be earning $20 a year on a $1000 deposit or investment. That is a 2% per year interest rate. If you earned SIMPLE interest, or interest on the principal only, the account would earn a flat $20 each year.

Compound interest allows interest earned to also earn interest. So the $1000 + the initial interest earned of $20 = $1020 and 2% interest earned on that in the next year would be $20.40. Over time that makes your money grow faster. Compound interest is great for investments and savings.

But compound interest can also work against you as credit card companies use compound interest on your balances. So what may have been a really great idea at the store for cute shoes or a a technology upgrade, when not paid off quickly, may add up to a much more expensive purchase.

Compound interest: a great tool when you are saving. But works against you if your have credit card debt.
Citations:

http://money.usnews.com/money/blogs/my-money/2010/07/21/how-compound-interest-really-works

 

http://www.learnvest.com/knowledge-center/compound-interest-101-how-it-works/

Marion Syversen, MBA
NorumbegaFinancial
207.862.2952
Marion@NorumbegaFinancial.com
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