What Does Compounding Mean When We Talk About Money?

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A wise man once said that compounding is the 8th wonder of the world:

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it” – thought to be Einstein

But what exactly is compounding?

This is what I like to call: “money making money babies”.

Money Making Money Babies

When you put money in the bank, you’re rewarded with a small sum of money called an interest rate. At the moment, interest rates are less than impressive. We’re looking at numbers that barely scrap over 1%! So in other words, if you save £10,000 in the bank and the interest rates is 1.35%, then by the end of the year you’ll have earned £135. This is the money baby that your money has made.

The next year if you’re lucky, the interest rate is still 1.35%. Now you start with £10,135. By the end of the year, you’ll have £10,271.82. The money baby has made it’s own babies – and so the cycle continues, providing your savings account maintains the same rate.

Unfortunately most accounts drop in rate to less than 1%, and will stay like that until you switch your account (which most people don’t do because we have too much going on in life to notice and/or care.

Banks Understand Compounding

Unfortunately, the banks understand compounding REALLY well and use it to their advantage (and our detriment) – they’re a business at the end of the day, and they need to make money.

So while the banks only give 1-2% of interest on our savings, they CHARGE 15%+ for LENDING money on a credit card to you (lower if a loan, but credit cards are not good). This means that their money is making LOTS of money babies very fast – it’s the equivalent of rabbits when it comes to baby making!!

A definition of compound: “to make (something bad) worse; intensify the negative aspects of”

So the goal is to stop feeding the banks by paying off debt as fast and as hard as possible, and then put your own money to work better than what the banks are offering you – and that means you need to start investing.

The Rule Of 72

This is quick rule to use to work out how quickly your money is compounding – it measures how fast your money will double.

It’s so easy – start with the interest rate you’re looking at – let’s say 3%.

Now you just do this – 72/3 = 24 this is the number of years it will take for your money to double sat in the bank.

Now work it out for a credit card at 24% interest – 72/24 = 3 this is the number of years it would take for your debt to double in size at a rate of 24% interest…. it’s barely any time at all!

What you do next is up to you

So now you understand compounding and have a nice quick way to work out the speed at which your money grows, now you can work out what you need to do.

The bottom line is: get out of debt, spend less than you earn and invest the difference in decent quality investments to get your money making money babies.

How you do it is down to you.

Until next time,

 

 

 

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