What exactly is…compounding?PUBLISHED ON Thursday, 9 December 2021
When people talk about your money ” growing by itself” or “working for you”, they are indirectly talking about the compound interest or the compound interest effect.
But what exactly does this mean? Apart from probably the only thing we ever learned in math class that is of any relevance to our everyday lives. Or how often do you still do curve sketching these days?
Why we love compounding
When you invest your money, you (optimally) receive interest on it. This interest is either distributed at the end of an interest period, i.e. paid out, or automatically reinvested. If the latter is the case, your invested assets grow by the interest income, which in turn earns you interest in the next interest period and brings in new interest income. The so-called compound interest effect occurs.
Due to the ever increasing interest (and compound interest) income, your assets also grow faster and faster. Let’s love! The compound interest effect, with its exponential growth, is therefore an incredibly important means of achieving your financial goals.
To allow compound interest to take full effect, it’s vital that you start investing your money early. Time is money in this case.
Your money needs time.
This sounds abstract and perhaps a bit complicated at first. (Hello math class!) However, an illustrative calculation makes it quite clear what a wonderful thing compound interest is and why the investment period plays such a big role.
Let’s assume that you invest 100 euros every month, in an ETF savings plan that yields an average of 5% interest or return per year.
If you start at the age of 20 and make the monthly payment until you are 60 years old, you will have paid in 48,000 euros at the end. Due to the compound interest effect, your assets have grown to a total of 148,856 euros, so you have earned over 100,000 euros just from compound interest!
If you start to invest 100 Euro every month at the age of 30, you will have invested 36.000 Euro at the age of 60. At the end, your assets have grown to 81,870 euros. Your returns therefore already amount to just under 45,000 euros.
If you start investing 100 euros every month at the age of 40, you will have accumulated 24,000 euros at the age of 60 and your assets will amount to 40,746 euros. At 16,000 euros after 20 years, your returns from interest and compound interest are much lower than they would have been after 30 or 40 years.
Cheers to love, money and the balance between the two
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