Compounding interest is the power of money. Banks will pay you for letting them keep your money with them. The reason that they do this, is because your money doesn’t just sit at the bank until you’re ready to pull it out. Banks use their customers money to lend to others in the form of personal loans, mortgages, credit etc. They charge other customers an interest rate, which is their cost for borrowing money, and in turn, the bank gets a profit, and they pay their customers a dividend, or interest. This is how banks make their money.

Now with compounding interest, your money has the power to make more money with time. Calculating the future value of your money is easy. The formula is :

fv=p(1+r)

fv= future value
p= Principal
r= rate of return

So if you have a principal of $1000 that you put into your bank and the rate of return is 5%, then the future value will be 1000 (1+.05)= $1050. This shows that you will earn $50 at the end of the compounding interest cycle (usually 1 year, but can be as often as 4 times per year depending on  where you have your money). It might not seem like a lot, $50 for an entire year, but here is the magic of compounding interest. Leave that $50 in the bank, then for the next compounding interest cycle, you will get $1050 (1+.05)=$1,102. How is that for a better jump.

So you see that that measly $1000 that you put in, with an average rate of return of 5% for 10 years will turn into $10,500. Keep your $1000 under the  mattress and that $1000 will still be $1000, but might be worth less because of that evil little thing called inflation. Use that $1000 to buy a television and then its worth even less. 10 years down the line, would you rather have an extra $10,500 you did nothing to make but put into the bank, or a 10 year old television?  Seems obvious right?

To see some more examples of how compounding interest works, try a few more formulas, or better yet, visit some of the compounding interest calculators below. There is also a new iPhone app that calculates compounding interest making it even easier for people to choose investment options.

iTunes

Money Chimp

Math.com