What makes compounding special is, the amount gained increases each time it compounds. The basis for making compounding work is that the gains are reinvested.
Imagine starting an account with $100 that grows at 5% annually. At the end of the first year the balance is $105. It grew by 5%, 0.05 * $100 = $5. You let the extra $5 ride, reinvesting it. The second year, it grows by 5% again to $110.25, gaining 0.05 * $105 = $5.25. Again you let it ride. Each year it gains a little more and you never touch the balance. By the 20th year the total balance is $265.33, and 5% of that is $13.27!
- Principal - the starting balance.
- Interest rate - the rate the money grows at. An average annual return in a conservative portfolio with 50% bonds and 50% stocks might be 5%.
- Term - how many years to compound.
- Compound Frequency - how often does the balance compound (yearly, quarterly, monthly, twice monthly). The more frequent the contributions, the more it grows.
- Contribution or Withdraw Amount - how much to add or subtract from the account each compound period (eg, if you are compounding monthly, this would be a monthly contribution).
- Inflation - the inflation rate, optional.
How to make Compound Interest work in your favor:
- The longer the term the better off you'll be. So start saving now, and keep saving as long as you can!
- The more frequent the contribution, the bigger the account gets over time. Finance gurus call this 'paying yourself first'. You can make this happen in your sleep by setting up automatic contributions to your savings / investment accounts. For example, assuming you have a retirement plan at work, ask your HR department to defer X% of every paycheck into your retirement plan each month. For self directed accounts like Roth IRAs or a personal savings account, your bank / brokers should have a way of configuring automatic contributions, typically through their website. Financial institutions make it easy and free to automate contributions (since they want your money).
- In our example we didn't include taxes. If your money is growing in a taxable account (like a typical savings account or brokerage), uncle sam is going to take a cut every year, reducing your rate of return. However if your money is in a tax deferred account like a 401k, IRA, etc, then it grows tax free!
The take away is contribute early and contribute often.
On the effects of inflation:
Even though a calculation above may show numbers that look big in 30-40 years, what that money will actually buy in 30-40 years will be reduced by inflation. Inflation is an increase in prices, but not in value. For more about inflation see our article Inflation - Why Prices Usually Go Up.
Inflation erodes the real value (purchasing power) of an investment. For example, say in 1990 a bar of soap was $1, and in 2017 the same bar of soap is $1.84. The nominal value went up (to $1.84), but the real value of the bar of soap stayed the same (a bar of soap is still just a bar of soap). This analysis excludes changes in supply and demand that may have impacted the price of the bar of soap. For the sake of argument, let's assume the $0.84 change was completely due to inflation. Check out our inflation calculator with this example.
- This calculator assumes that contributions are made at the end of each contribution period, after compounding is applied.
- See our article on compound interest for more information.