What Is Compounding?
Compounding is earning returns on your past returns as well as on the money you put in. How it works, the arithmetic, the rule of 72, and why time matters so much.
In one sentence
Compounding. Earning returns on your earlier returns, not only on the money you originally put in. Over time it makes growth speed up.
How it works
When an investment earns a return and you leave it invested, the next return is earned on a bigger amount. Interest earned on earlier interest is the classic case. Each year's growth is larger than the last, even at the same rate.
| Years | Value | Growth in the last 10 years |
|---|---|---|
| 10 | $19,672 | $9,672 |
| 20 | $38,697 | $19,025 |
| 30 | $76,123 | $37,426 |
| 40 | $149,745 | $73,622 |
The fourth decade adds more than the first three combined. Real returns are never this smooth, but the shape is the same.
The rule of 72
A quick estimate: divide 72 by the yearly rate to get roughly how many years it takes to double. At 7%, 72 ÷ 7 is about 10 years, which matches the table.
It works both ways
Compounding also works against you. Fees take a slice every year from a growing balance, and debt left unpaid grows on its own interest. Inflation. A general rise in prices over time. When prices rise, the same amount of money buys less. More on this term compounds too, which is why a "real" return subtracts it.
Learn it properly
- What Is Investing?Part 1: Foundations · Free
- CompoundingPart 1: Foundations · Free