Compounding is very powerful phenomenon if done over a long period of time. But it is also widely misunderstood. Compounding in our money savings context is simply how we allow any interim returns on our money be reinvested with the original principal.
Consider a bank that promise to give you 10% return every year. If you put $1000 of your money in a bank account, you will get $100 at the end of every year from the bank. You will then face two possible choices: either take your $100 and spend it; or re-invest those $100 back into that bank account. If you choose to reinvest, the bank will then return 10% on your new combined investment of $1100 i.e. $110 at the end of the second year. You do that for about seven years and you will have doubled your total savings.
Here are the numbers ..
Note how by year 15, you’d have more than quadrupled your original investment. In 20 years, you will be up by 6.7 times.
Key here is reinvestment. You must keep reinvesting your yearly earnings to make it grow so fast. If you get greedy and take your earnings out, you will miss out on this compounding magic.