Albert Einstein was once asked what he thought was the most powerful force in the universe. His answer was “Compound interest.”
I think the term compounding can best be understood through an example. Say a bank lent you $1,000 at a rate of 20%/year, compounded. After the first year, you owe the bank $1,200. After the second year, you don’t just owe $1,400, but $1,440. In the second year, it’s as if you paid back $1,200, and borrowed at 20%/year again.
Therefore after the second year, you owe $1,200 x 1.2 = $1,440.
Compounding turns money into a snowball. The bigger the amount, the faster it grows, and like Einstein said, that can be a very powerful force.
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