**Compounding**

*“Compound interest is the eight wonder of the world. He who understands it, earns it… he who doesn’t… pays it.” ~ Albert Einstein.*

Compounding is what happens when you reinvest the interest income you earn from loaning your money. **Compound interest **is the interest that is earned on *reinvested* interest income. Take our previous example (in 1 – Time Value of Money and Interest Rates) of U.S. Treasury Bonds paying 1.75% interest per year. We initially invest $100 (at the beginning of year 1), and at the end of year 1 we earn $1.75. If we choose to reinvest that $1.75, instead of spend it, that $1.75 will be added to our original capital base of $100, and it will help us generate even more interest over year 2.

*Original Capital Base (beginning of year 1) = $100*

*Interest Payment (received at the end of year 1, and reinvested) = $1.75*

*New Capital Base (end of year 1, beginning of year 2) = $101.75*

So how much interest will we receive at the end of year two? We’ll earn $1.78. ($101.75 x 1.75%).

If we add that $1.78 to our capital base, how much will we earn at the end of year 3? $1.81.

You can see how this amount adds up. After three years, we’re earning more than our original $1.75, simply because we chose to reinvest the proceeds!

I realize this example seems ridiculous. What can a person do with three extra pennies at the end of one year, and six extra pennies at the end of the next? So, let’s up the ante and use a more dramatic example.

At the time of this writing, you can purchase preferred stock of Wells Fargo Bank for about $28 per share. Don’t worry about what preferred stock is, just know that it’s similar to a bond, only this bond yields 7% per year!

*Note: the income we get from stock we call dividends, while the income we get from bonds is called interest. *

7% of $28 is about $2.00. This is what we’ll get paid at the end of year 1 by investing our $28 in Wells Fargo’s preferred stock. If we reinvest our $2.00 at the end of the first year, our capital base will grow to $30 ($28 + $2 = $30). Since our investment in Wells Fargo’s preferred stock still yields 7% per year, our new capital base of $30 will pay us $2.10 at the end of year two. Add this $2.10 to our capital base for year three, and our income at the end of year three will be $2.25. If this continues, our initial investment will double in ten-years! Simply by setting aside $28 and letting it earn 7% interest (or in this case, dividends), and letting that interest compound, we can double our money in ten years!

*The Rule of 72. You can find roughly out how long it will take your money to double when compounding by dividing your interest rate into 72. E.g. at 7% interest, your money will take (72 / 7) 10.3-years to double. At 9% interest, your money will take (72 / 9) 8-years to double.*

Compounding, simply put, is the exponential growth of money due to the reinvestment of interest and/or dividends. Compound interest is the interest that you earn on reinvested interest payments. It is a powerful concept – available to all but only used by few.