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 But there’s one caveat: the returns or interest you receive needs to be reinvested and not withdrawn or spent.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