This post was originally posted on our Financial Education Website, Build Your Financial Future. You can see the original post here.
It sounds like a word they would use on a farm.
As in, “I’ve got some compounding to do down on the back forty so I won’t be able to shuck corn with ya this afternoon”.
In reality, compounding is just one more of those financial terms that many have heard, but few can explain. The first thing you should know about compounding is, obviously, that it is fun to say. The second thing you should know about compounding is that it can be both a force of good and a force of evil in terms of your finances.
In simple terms, compounding occurs when the interest charged/earned is added to principal (the starting amount) and then is charged or earns additional interest. Perhaps a real-world example will help to further clarify.
A REAL-WORLD (Sort of) EXAMPLE OF BAD COMPOUNDING
You are given ten screaming toddlers (a credit card debt). For every hour that you don’t find their parents (make a payment), you will be given 20% more screaming toddlers (interest).
In the first hour you don’t find a single parent. Bummer.
Now you have:
+ 2 Toddlers (10 x 20%)
In the second hour you still don’t find a single, solitary parent. Big bummer.
Now you have:
+ 2.4 Toddlers (12 x 20%)
So not only is your problem growing, but it’s also growing at an increasingly disgusting rate. It’ll get messy faster than a room full of toddlers.
But remember how I said compounding can be a good thing?
A REAL-WORLD EXAMPLE OF GOOD COMPOUNDING
Take the last example, delete all the “crying toddlers” and replace them with something you enjoy, like puppies or, I don’t know, MONEY. I’ll get you started. You invest $10 in a stock. You get 20% more money from a dividend…
Now you don’t have a problem that’s growing faster and faster, you have a good thing that’s growing faster and faster.
TIME IS OF THE ESSENCE
Whether working in your favor or to your detriment, when it comes to compounding, time matters. In the worst case, it’s like paying a fee on a fee on a fee on a fee, times infinity. In the best case, it’s like earning on your earnings on your earning’s earnings, also times infinity.
- Pay off debt quickly.
- Pay off high interest debt even more quickly.
- Save early.
- Save consistently.
- Reconsider a profession in childcare.