Power of Compounding Interest

Investment advisors often advocate us to start investing while we are young, so that we can benefit from the power of compounding interest. But a lot of you may ask, "what is that"?


The idea behind this is very simple. After the investment of an initial principal sum, you will receive some interest from it on an annual basis. Subsequently, you will reinvest this interest in the product so that you can receive even higher interest on the next year. This cycle is repeated until you stop your investment. Lets do some simple calculation.


Imagine that you have a principal sum of $10,000 and the annual interest from your investment is 5%.


End of year 1, you will have obtained interest of $500, from a principal of $10,000.
End of year 2, you will have obtained interest of $525, from a principal of $10,500.
End of year 3, you will have obtained interest of $551, from a principal of $11,025.
End of year 4, you will have obtained interest of $578, from a principal of $11,576.
End of year 5, you will have obtained interest of $607, from a principal of $12,154.
End of year 6, you will have obtained interest of $638, from a principal of $12,761.
End of year 7, you will have obtained interest of $670, from a principal of $13,399.
End of year 8, you will have obtained interest of $703, from a principal of $14,069.
End of year 9, you will have obtained interest of $738, from a principal of $14,772.
End of year 10, you will have obtained interest of $775, from a principal of $15,510


At the end of 10 years, your principal plus interest will amount to $16,285.
This is effectively about 62% of your initial investment amount.


However, if you do not reinvest the interest, you will only be getting $5,000 of interest over 10 years, which amounts of 50% of the initial investment amount.


So comparing the 2, you will have obtained about 12% more of the original invested amount over 10 years just by reinvesting the interest! So it certainly pays to reinvest your interest if possible. The hard part is to make sure that your investment can constantly generate yield at that percentage.