Time is money.
Coined by a Founding Father, Benjamin Franklin, this oft-repeated phrase tells us that we should use our time wisely and productively. If we don’t, our actions could lead to financial loss, and we may miss out on valuable money-making opportunities.
Sounds pretty ominous, doesn’t it? Not in the case of compounding, or compounding interest, as we frequently hear the word. Time is compounding’s best friend, a magical force for financial reward.
Morgan Housel writes in his book, The Psychology of Money, about “confounding compounding.” It’s confounding (or confusing) because the concept is hard for us to grasp. Compounding interest is simply too good to be true.
The process of compounding is defined as adding earned interest back into the principal, or original sum of invested money. I imagine compounding as literally putting dollar bills received in interest back into the “pot” of principal to start earning interest on itself in the next period. This means your money grows at an accelerated rate as the earnings from each period are reinvested and generate additional returns.
Example: You invest $100 with a 5 percent interest rate and earn $5 in interest after the first year, bringing your total to $105. The next year, you’ll earn interest on $105, not just $100, and so on.
Many investors liken compounding to a snowball rolling downhill, growing bigger as it accumulates more snow along the way. “The important thing is finding wet snow and a really long hill,” said Warren Buffett.
The two secrets to compounding success: time and money.
“None of the 2,000 books picking apart Buffett’s success are titled, ‘This Guy Has Been Investing Consistently for Three-Quarters of a Century,’ writes Housel. “But we know that’s the key to the majority of his success.”
The sooner you get started, the more time your investment has to grow, thanks to compounding interest. Additionally, maintaining consistency in investing enhances the power of compounding.
“ … Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can’t be repeated,” Housel writes. “It’s about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That’s when compounding runs wild.”
Tip: Automate regular contributions from your bank account to your investments each month. Over time, you won’t flinch when you see the automatic withdrawals from your bank account, but you will do a happy dance when you see the compounding effect create significant returns.
Unfortunately, the same principle of compounding interest applies to debt. Just as it works its magic on building wealth, it does the same, but working against you, with debt.
This means that if you don’t pay your balances in full each month, especially high-interest credit cards, any unpaid interest gets added to your principal. Then the next month’s interest is calculated on this larger amount, creating a cycle where your debt grows faster and becomes harder to pay off.
Tips to avoid compounding interest with debt:
• Pay more than the minimum to reduce the principal and amount of interest you’ll pay over time.
• Prioritize high-interest debt and pay those off first.
• Be mindful of compounding frequency, or how often interest is compounded (e.g., daily, monthly) as it can affect how quickly your debt grows.
The magic of compounding isn’t really an unknowable force at all. It’s what happens when you give your money two things: time and consistency. Start early, keep investing, and let your returns build on themselves.
Your future financial self may not be able to thank you today, but given enough time, you might be glad you finally got started.
Lindsey D. Rhea, CFP, is owner and wealth strategist at Alia Wealth Partners, connect@aliawealth.com.
