Compounding gets thrown around a lot when people talk about money and personal finance. And often, the people using the word just assume that whomever they’re talking to will know what it means.
Except that not everyone knows what it means — because let’s face it, high school didn’t do much to help most of us learn about real-life money management.
So … what is compounding?
Compounding is what happens when you take a number and increase it over and over again by a percentage (think “10% annual growth”). That’s opposed to increasing it by a fixed number (think “add 10 each year”).
To demonstrate how the mathemagical phenomenon of compounding works, let’s use a delicious example: lattes. (ICYMI, we’re big on lattes here at Ellevest.)
OK, say you drink 100 lattes a month. That would be a highly concerning caffeine level, but we’re trying to make the math easy here. So one day, your fairy frothmother shows up and tells you that she is granting your wish: That milky (or soy milky or oat milky) goodness will increase by 10% every month.
OK, so 10% of 100 lattes is 10 more lattes, right? Right. So here’s how you might assume that would look:
Month 0 (when you start): 100☕
Month 1: 100 + 10 = 110☕
Month 2: 100 + 10 + 10 = 120☕
Month 3: 100 + 10 + 10 + 10 = 130☕
Month 4: 100 + 10 + 10 + 10 + 10 = 140☕
Month 5: 100 + 10 + 10 + 10 + 10 + 10 = 150☕
Total extra lattes after 5 months: 50☕
But that’s not actually how compounding works. You don’t just get an additional 10% of your original 100 lattes every month. Instead, you get an additional 10% of your total number of lattes every month (rounded below because who wants only part of a latte?):
Month 0 (when you start): 100☕
Month 1: 100 + (100 x 10%) = 110☕
Month 2: 110 + (110 x 10%) = 121☕
Month 3: 121 + (121 x 10%) = 133☕
Month 4: 133 + (133 x 10%) = 146☕
Month 5: 146 + (146 x 10%) = 161☕
Total extra lattes after 5 months: 61☕
Boom. When the number is compounded, you end up with more coffee in the end. That’s the magic. (Very high-energy magic.)
Got it. What does this have to do with my money?
There are two main ways compounding comes into play when it comes to money: compound interest and compound returns.
As you might expect, this comes into play when you’re earning interest on your money. For example, if a savings account pays the current national average of about 1%, then your money will increase by 1% every year. (Like the coffee, but not as delicious.)
But compounding can work against you, too — like when you owe compound interest on debt. For example, if the annual interest rate on your credit card is the current national average of about 18%, then the amount of debt you owe will increase by 18% every year. (Definitely not as delicious.)
Compound returns usually come up when we talk about investing. In this case, you aren’t earning interest, which is a promised, steady amount — you’re potentially earning investing returns, which are definitely not guaranteed and definitely not steady. But they can be super powerful.
Here’s an explainer on how investments can make money. But to make that long-ish story short, when the value of the individual investments you own, like stocks and bonds, goes up (or down), that makes the balance in your investment account go up (or down). As long as you leave the difference invested, then your returns have the opportunity to compound over time.
So if the markets were to go up for a big chunk of the time you had money invested, compounding would work in your favor. And yes, that goes the other way too if the markets decline — that’s why we say that investing comes with risk. BUT. The longer you let compounding work its mathemagic, the more likely you are to have overall positive returns (at least, that’s been the case historically). Case in point: Stocks are typically the riskiest part of an investment portfolio, and they’ve gone up in about 75% of years since 1928 — in fact, the stock market’s average annual return has been about 9.5%.
So getting started ASAP is a big deal — the higher your account’s balance and the longer your money’s invested, the more opportunity it has to compound over time.
Every day you wait is a day you miss out on the opportunity to start compounding. We’re talking about real money here — by our calculation, it could be about $100 a day. That’s like giving yourself a pay cut of over $17 an hour. Or nearly $3,000 a month.* Yup.