Compounding is an extremely powerful thing. For those that understand how it works it can lead to great wealth over a long time from a modest starting point. Anybody can use the compounding effect to their advantage and get rich slowly. In this post we’ll take an in depth look at what compounding is, how to calculate it and how to create your own compounding interest sources.
What Is Compounding Interest?
Compounding is a type of interest applied to a financial product. Interest is a charge that is applied for borrowing money. When it comes to interest there are two main types to consider – simple and compound.
Simple interest is the most basic form where interest is only applied to the principal amount. This can provide an investment income but does not offer as attractive longer term returns as compound interest.
This is because with compound interest, the interest is applied to both the principal amount and the interest being accrued. Over time this earning of interest on interest really starts to accumulate and provides a snowball effect. This is why it is a way to get rich slowly. We’ll explain the compounding formula further on with some examples to demonstrate exactly how it works.
How Compounding Works
Getting rich slowly and building wealth over time requires patience. It is about investing for the long haul and not making decisions based on short term trends and price movements.
So compound interest works by applying interest to the initial amount deposited and on the interest that this generates. This can generate very large long term returns as we’ll see in the examples below.
Interest may be applied to various compounding periods. For instance, some may apply interest annually whereas others could even be daily. These variations in interest periods can effect how quickly returns are compounded.
First, let’s take a look at both the simple interest formula and the compounding formula for calculating total returns. Total return is what you have made in total at the end of the specified period. This is the combination of your initial money invested plus all returns made.
Simple Interest Formula
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The formula may look complex but it is relatively simple to calculate using a scientific format calculator. The ^ symbol means ‘to the power of’.
P = Our initial deposit
r = Must input as a decimal number. To do this simply divide by 100. So 10% interest would be 10/100 = 0.1
n = Number of compounding periods per year. E.g. annual compounding is once per year so would input 1.
T = How many time periods you wish to calculate for. For example, you need to know how much you would receive after 5 years so you would input 5.
We’ll show an example of both simple and compound interest in the infographic below so it will become clearer and highlight the differences between the two.
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Where Can You Earn Compound Interest?
Many types of investment asset accrue interest, however not all pay compounding interest. Common assets that compound are cash, stock dividends and many types of debt instruments.
Some assets pay simple interest such as bonds and P2P loans. But the returns from these can usually still compound. To do this, just re-invest interest payments back into the same asset. This in turn buys more units and further increases the amount of interest income paid out.
Cash is probably the asset that most are familiar with as all interest paying bank accounts use compound interest. When you deposit cash into a savings account at your bank you are actually lending your money to the bank.
In return for lending money, the bank pays you interest on your deposit. The bank uses this money to fund their other areas of business such as loans and mortgages. They make a profit by lending out to others at a higher rate than they pay you on your savings. View the best online savings accounts interest rates.
Dividends perhaps provide one of the greatest ways to get rich slowly through a process know as dividend compounding. We’ll discuss this in detail in the next section.
How To Get Rich Slowly From Dividend Compounding
Firstly, what are dividends? Dividends are a reward payment made to shareholders by a company from it’s earnings. They are not an interest payment as such but can be thought of to work a bit like it.
The amount a company pays out as a dividend is expressed as a percentage know as a dividend yield. This is basically the amount paid as a dividend expressed as a percentage of the share price. So for example a company with a share price of $100 pays a dividend of $10 per share, the yield would be 10%.
Not all companies pay dividends and those that do can sometimes reward shareholders in different ways. For more information see the different types of dividend.
Although cash dividends are still most common among dividend paying stocks. That presents two options – use the cash as a regular source of income to do with as you wish. Or if you want to get rich slowly then simply re-invest this cash back into the same shares.
By re-investing dividend payments into purchasing more of the same shares you will then own more shares in that company. This means that you will receive a larger dividend payment next time as you now own more shares. Re-invest this again, which will buy yet more shares and in turn an even larger dividend payment.
If a company increases it’s earnings over time this is often passed on to shareholders through regular increasing dividends. In addition, good performing companies should see rises in their share price. This is known as a capital gain – where the asset price has increased in value from the price you purchased at.
2 Ways To Get Rich Slowly With Shares
Whilst cash offers security over shares, shares offer greater growth potential. Cash savings only provide compound interest. Whereas dividend stocks can provide the combination of dividend compounding and capital gains to really skyrocket overall returns.
The combination of dividend re-investment and capital growth when left for a long time horizon has potential to substantially grow even the smallest initial investments into great wealth. If left for long enough, your dividend returns alone can exceed your initial investment. Which is why it’s important to start investing earlier as you have a longer time horizon for growth.
Many investors are impatient and never benefit from the compounding effect as they are unable to look beyond short term returns. Constantly moving in and out of the market and chasing the hottest stocks is usually not as profitable in the long run. Dividend compounding may not seem very exciting but it is a sure fire way to get rich slowly.
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Get Rich Slowly Conclusion
Compound interest is preferable to simple interest to an investor. Interest can really start to accumulate quickly by applying interest on interest, giving a snowball effect.
Any investment that provides an income can be made to compound. Simply re-invest your income back into purchasing more of the same asset. This increases your holdings and earns greater income. The process continues, each time purchasing more of the asset and in turn more future income.
Stock dividends can provide both dividend income and capital growth. It is this combination that when re-investing dividends produces an enormous compounding effect over a long period of time.
Start early, prepare to invest for the long-term, be patient and you too can harness the power of compounding. It is a proven way to get rich slowly.
Use the M1 Finance Super App to help manage all your investing as well as regular day to day banking. It is packed full of smart features, tools, strategies and automation to help those with a long term view to make more of their money and build wealth.
View our blog for lots of posts exploring the different types of investments including;
- 10 investment ideas to grow your wealth.
- What are shares and how do they work?
- Make passive interest income to boost your earnings.
- The difference between trading and investing.
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