Tag: Compounding

My wealth has come from a combination of living in America, some lucky genes, and compound interest“

– Warren Buffett

Compound interest means interest on interest. It is the result of reinvesting interest, rather than taking it out.

To understand the concept, let us assume $10,000 is invested @ 5% interest which is withdrawn at the end of each year. Total simple interest earned will be $ 1500 at the end of 3 years

Year	Principal	Interest @ 5% p.a.
1	10,000	500
2	10,000	500
3	10,000	500
	Total interest	1500

Let us assume $10,000 is invested @ 5% interest which is reinvested at the end of each year. This means at the end of year 1, interest earned $ 500 will be added to $ 10,000 principal and interest will be calculated for year 2 on $ 10,500 amounting to $ 525. Total cumulative interest earned will be $ 1576 at the end of 3 years

Year	Principal	Interest @ 5% p.a.
1	10,000	500
2	10,500 (10000+500)	525
3	11025 (10500+525)	551
	Total interest	1576

We can see that compound interest results in interest of $1576 at the end of 3 years compared to simple interest of $ 1500, i.e. an extra interest of $ 76 by just keeping interest reinvested.

One can see, how power of compounding can help grow your wealth much faster.