From the monthly archives:

April 2009

The Power of Compounding: What Does It Mean?

We’ve all heard how investing can provide passive income and help us reach our long-term goals. But for those who do not have much money to invest, it may not seem worthwhile. When you consider the effects of compounding, however, it’s easy to see just how much sense investing makes.

Compounding occurs when an investment gives returns on both the original amount invested and the interest or returns previously gained. That means you can increase your money even if you do not add anything beyond the initial investment. Compounding takes time, but once you’ve left that money untouched for several years, you can experience impressive gains.

To illustrate how compounding works, consider an investment that provides a 5% annual return. If you were to invest $1,000, you would get a return of $50 after a year. With that additional $50 drawing interest as well, you would have $1,102.50 a year later. These gains may not seem like much, but after 25 years, that initial $1,000 investment will have earned you $2,481.29, for a total of $3,481.29. Basically, you’ve earned an average of about $1,000 per year for doing nothing.

Compounding is powerful when you only invest once. But just imagine the gains you could experience if you made regular contributions. This is how retirement and college savings plans work. Investors make a small contribution each week, month or year. All of the money that was previously in the account earns interest, as do the new contributions and the interest previously earned.

The key to taking full advantage of compounding is to start saving as early as possible. For college funds, that means starting when your children are young (or even before they are born). For retirement funds, it’s wise to start contributing as soon as you enter the workforce.

Most employers that provide benefits offer a 401K plan, which allows employees to make contributions through payroll deductions. The employer often matches the contribution up to a certain amount, and all of the money in the account gains interest. Over a period of 40 years, you should have plenty of money to retire on.

You can save up money for education and retirement even if you start late. But you’ll have to invest much more money to end up with the amount you would have had if you had started earlier. The key factor in compounding is time, so the sooner you start saving, the better off you’ll be.

It’s easy to get discouraged when you put your hard-earned money into an investment and do not see big returns right away. But if you give time for compounding to work its magic, you’ll find that your money grows more each year.

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