“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein.
Compounding or compounding interest is a process of earning interest not only on the principle of an investment, but on previously earned interest as well. This compounding effect has the ability to turn a small amount of money into a large sum over time. The longer this compounding effect is able to occur, the more interest you will earn.
Compounding growth can be compared to rolling a snowball down a hill. In the beginning the ball is small in size and it SLOWLY starts rolling from the peak. As the ball keeps rolling, it starts getting bigger and as it gets bigger it starts rolling faster. The longer it rolls the bigger it gets until a massive ball is formed. The massive ball would continue to grow to infinity if left alone in this process. Here are a few examples of this compounding effect in action.
Compounding Interest In A Bank Account
Let’s deposit $100 in a savings account paying 5% interest per year. At the end of the first year you would have earned $5 in interest. The second year you would have earned 5% on the original $100 PLUS the previously earned $5 in interest. The bank account would look something like this over 10 years:
As you can see, the interest really starts compounding as time progresses. To bad most bank accounts these days pay less than 1% interest.
Compounding Growth With Dividend Stocks
Let’s invest some money in Loonie Bin Inc. which has a share price of $32 and pays a yearly dividend of $1.35 per share. Purchasing 100 shares for $3200 would generate $135 a year in dividends. If we took that $135 and purchased more shares of LBX at an average share price of $32 the following year, we would then have 104 shares paying $140.40 in dividends. After twenty years in a dividend re-investment plan (DRIP), you would have an investment that looked something like this:
An initial investment of $3200 now pays $288.90 a year in dividends and there are now an additional 114 shares.
Compounding Growth With Contributions
While compound growth works well on its own, adding additional contributions will increase the compounding effect exponentially. Let’s use the above example and add $5000 a year as a TFSA contribution from years 2-20. To make it more realistic we can increase the dividend and share price by a conservative 5% each year from year 2-20. The outcome would look something like this:
I tried to make the chart so that all the important information was documented so don’t freak out if it’s confusing. Basically we’ve invested $98,200 over 20 years and we now have 3108 shares of Loonie Bin Inc. worth $251,312.88 and we receive $10,602.58 each year in dividends. Sounds good to me!
Notice if we stopped investing after 10 years the investment would only be worth $72,474.40 and the yearly dividend income would only be $3057.67; less than a third of the 20 year amounts. Those extra 10 years of compounding really add up!
ust imagine how much an investment could grow over a 30 or 40 year time frame! That’s why it’s so important to start investing for your future as early as possible. Why work hard to grow your wealth when your money can work hard for you with the power of compounding?
This article was written by The Loonie Bin. If you enjoyed this article, please consider subscribing to his feed.