First of all, what is interest?
Interest is the cost of borrowing money. The person doing the lending gets a fee for allowing the borrower to use their money for a set rate of time. The original amount that is loaned to the borrower is called the principal and the percentage of that original amount which is paid over a period of time is called the “interest rate.” That percentage times the principal is the interest. For example lets take Dave and John.
Dave: John I need to borrow $10 to buy a qdoba burrito. I will pay you back tomorrow…
John: Why would you buy a qdoba burrito?
Dave: It tastes good.
John: Ok, here is $10 but I will charge you 10% interest per day on that.
John: Ok that will be $10 + (10% X $10) so, that will be $11 please.
Dave: whoa $11?
John: Yeah, you should learn what interest means.
So what is compounding interest?
Compounding interest means that whenever interest is calculated, it is based on the original principal AND also any interest that has been earned. So the more often that that the interest is compounded, the faster the total (principal + earnings) grows.
What is this important for me?
Compounding interest is what allows something now to be worth many times the original investment many years from now (say, retirement age). Check out my retirement section for a bunch of examples of that.
How can I calculate compounding interest?
There is a rule called the rule of 72 that makes this fairly easy. It’s not exact, but it gives a pretty good approximation. 72 divided by the interest is equal to the number of periods needed to double the principal. So:
72/i = n
What is a typical example of this?
The stock market. Over the past 75+ years the stock market has averaged a rate of growth of around 11% per year. So if we say 12% just to make dividing 72 easy, thats 72/12 = 6. So at 11% per year it would take just over 6 years to double your money. Thats why people always talk about 6-7 years to double your money investing. It’s based on the average market return.