The short answer:
When you save or invest money, it has the potential to earn interest (as cash in a bank account for example) or returns (the percentage your investment grows every year). That percentage increase in value, is added to the original amount of money you started with and together continues to grow as time goes by. And so the cycle continues, allowing you to earn exponentially more year on year than what you would if you’re money was lying in a box somewhere – growing by, well, nothing. You earn interest on your interest and return on your returns.
The long answer:
We like practical examples and using pretend people with ridiculous celebrity kid names, to explain how stuff works. So we’re going to do just that to break down Compound Interest.
Meet Coco. (Hi!)
Coco is turning 16 and instead of surprising her with an ostentatious over priced luxury brand car and a spot on a reality show for her Sweet 16th, Coco’s parents have decided to gift her with some hard cold cash to the tune of R100 000. ‘Yas!’ Is what she thinks to herself, and because Coco has already met her Future Self and knows she wants to live like a Queen someday she saves the money. She locks it up in a vault (yes, in this story she has a vault) and resists the urge to spend it for 10 years.
Meet Willow. (Sup!)
Willow is also 16 would you know it. He’s just released his first single and it’s an instant hit! His record company gives him the good news that the first of (what will surely be) many cheques (yes, we’re still using cheques in this story) in his career as a rising star is about to drop in his bank account. The amount: R100 000. ‘Dope!’ Is what he thinks to himself, but because Willow’s teacher is always going on about investing in the stock market at school, he figures he’ll use the R100 000 to invest in a few different stocks.
10 years later
After 10 years, Coco’s money is exactly where she left it. It’s gone nowhere. Her R100 000 is sitting in the vault, a little dusty but sure enough it’s all there. But Coco has a sudden realization as she prepares to buy the latest iPhone, which costs a lot more than what it did 10 years ago. In fact everything does. Her weekly grocery shop, the price of a car and even the apartment she’s been eyeing as her bachelorette pad. The things she wants have 20Today price tags, while her money has a 20TenYearsAgo value.
Willow’s R100 000 did anything but stay in one place. It went up, and sometimes it went down. Sometimes it stayed put. Because the stocks of companies he invested it in grew in value overall, earning him an average of 12% return each year, he’s now sitting with R310 585. And that is the magic of Compound Interest, and it’s handy sidekick, Time.