You might have heard the term “compounding” thrown around in money conversations.

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Except that not everyone can casually rattle off the definition of “compounding,” because let’s face it: High school didn’t teach most of us about real-life money management. 

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Albert Einstein dubbed compound interest the “eighth wonder of the world,” and for good reason. It’s a financial force that can make your money grow exponentially.

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So, how does it really work?

Compound interest means that your money makes money, which then makes money, and so on - you get the picture. Instead of earning interest only on your initial investment, you earn interest on the total balance, which includes previous interest. 

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This simple process has a powerful snowball effect. The longer your money stays invested, the more it has time to grow – not in a straight line, but exponentially.

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Picture this: you invest $5,000 at 5% interest. After the first year, you’ll have $5,250. The next year, instead of earning 5% on your original $5,000, you’ll earn it on $5,250. This may seem small at first, but over time, it leads to meaningful growth. Investing $5,000 per year is about the amount of money you could spend buying lunch every day - so time to start packing those sammies!

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So what’s the secret ingredient? Time.

The earlier you start, the greater the impact of compounding. But hey, don’t stress if you’re a bit late to the party. There’s a saying: the best time to plant a tree was 20 years ago; the second best time is now.

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Someone who started at 20 and invested $5,000 every for 20 years and then left the money invested to compound, could have a healthy looking nest egg of over $615,000 at a 5% rate return. Starting later at age 30 could still give you a nice approx. $375,000, but you’ll have missed out on some of the benefit of the additional years of investing and compounding interest.

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Investing $5,000 per year at a 5% return compounded

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Compound interest rewards patience and consistency and can turn small contributions into long-term wealth.

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If Einstein was a fan, then we reckon we’re onto a pretty good thing.

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Written by Forsyth Barr Research – The expertise behind Tempo 💪