6 Steps to Reach Financial Freedom: Step 3

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The Power of Compounding

Simply put, compounding is earning a rate of return on your investments, assuming you reinvest all earnings. Suppose, for instance, you invested $200 and reinvested the full amount of your earnings each year. Also, suppose your investment returns 10% annually. Watch what happens to your earnings:

 

Year 1 Original $200 investment earns $20.

 

Year 2 Original $200 investment earns $20, $20 earnings from Year 1 earns $2.

 

Year 3 Original $200 investment earns $20, $20 earnings from Year 1 earns $2, $2 earnings from Year 2 earns $0.20.

Thanks to the power of compounding, your original $200 investment earns you $22.20 over 3 years.

The Early Starter versus The Late Bloomer
The most important lessons to learn about compounding are to start early and reinvest your earnings. The earlier you start, the greater your earnings over time. Compare the results of two investors in the table below: the Early Starter invests only half as much as the Late Bloomer, but by starting sooner, the early starter earns significantly more.

 

Early Starter Late Bloomer
Age Contribution Age Contribution
25 $2,000 25 None
26 $2,000 26 None
27 $2,000 27 None
28 $2,000 28 None
29 $2,000 29 None
30 $2,000 30 None
31 $2,000 31 None
32 $2,000 32 None
33 $2,000 33 None
34 $2,000 34 None
35 No more contribution 35 $2,000
36   36 $2,000
37   37 $2,000
38   38 $2,000
39   39 $2,000
40   40 $2,000
41   41 $2,000
42   42 $2,000
43   43 $2,000
44   44 $2,000
45   45 $2,000
46   46 $2,000
47   47 $2,000
48   48 $2,000
49   49 $2,000
50   50 $2,000
51   51 $2,000
52   52 $2,000
53   53 $2,000
54   54 $2,000
Total Contribution $20,000 Total Contribution $40,000
Total Earnings at 8% $135,042 Total Earnings at 8% $91,524

 

 

 

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