The basics of compound interest
Suppose you have $1,000 earning 5% per year. That’s $50 per year, right? Yes, but then it starts to compound. After that first year at 5% interest, you now have $1,050. Add the same 5% interest, and you get $52.50 the second year for a total of $1,102.50. The third year your total grows to $1,157.63 ($1,102.50 x 1.05). Yes, the extra gains over and above the original $50 in interest are small at first, but they pick up steam as time goes on.
That’s why it’s important to reinvest any compounded returns. If, instead of reinvesting that $50, you withdrew it and spent it on a nice restaurant dinner, you’d earn only another $50 the second year instead of the compounded $52.50. There’s nothing wrong with the occasional splurge, but when it comes to investing for the future, you can’t have your compounding and eat it too.
