Describe Compounding

Albert Einstein famously quipped that compound interest is the most powerful force in the universe. How can you explain this concept to someone of any age and background? Or ten fun examples of compounding.

1. Savings

Let’s say you put $100 in a savings account that pays 5% interest. At the end of the year, you will have $105. But if you do this for ten years at 5% interest, you will have $1,594. That’s because (1 + .05)10 = 1.5944 or a compounded increase of 944%. You can see how compounding is exponential growth.

2. Interest and Income

If you get 10% interest on your money and also make 10% income off your money (through investments), then your money will double every two years. This is why some people with high incomes are constantly worried about losing their jobs so they can maintain their lifestyle.

3. Taxes

When calculating taxes owed, it’s best to use the “money first” approach to compound growth rather than the “money last” approach. For example, if someone makes $100,000 a year and has a marginal tax rate of 25%, then it doesn’t matter if he puts his money into an account that compounds monthly or annually or even daily. But what matters is how many months until he gets his money back after taxes are taken out of his paycheck each month. If he has 12 paychecks a year, then he should probably use an annual compounding schedule when figuring out how much to save each month so that he can retire comfortably when he turns 65.

4. Real Estate Investing

4a: Cash on Cash return
A good real estate investor wants to make at least 15%. The reason is that 15% is called the “cash on cash return” meaning that 15% of your down payment goes directly into your pocket as profit (minus any expenses). So let’s say you buy a house for $200,000 and put down 20%, or $40,000 and borrow the other 80%. If you sell the house for $250,000 then your profit would be ($250 – 200) – 40 = $40,000 minus expenses such as broker fees and closing costs equals…$20,000! You made 20 grand just by putting down 20 grand! And this assumes no appreciation in value which is unlikely but not impossible given inflationary pressures which means prices go up over time. 4b: Cap rate
The cap rate tells you how much profit per year does a property generate compared to its price (the cap). So if I buy a house for $100k and rent it out for $1k/month then my cap rate would be 1k/month divided by 100k = 0.01 or 1%. Which means I am making one percent profit per year on my investment assuming there are no expenses associated with owning this property such as mortgage payments or maintenance costs or broker fees etc.. The lower the cap rate the better because it means more profits per dollar invested in buying properties like this one and managing them properly so they don't become "dogs" which happens all too often because everyone thinks real estate investing is easy money when it's not always easy at all but rewarding when done right. 4c: ROI - Return On Investment
This measures whether buying a property was worth it financially vs other investments available to me such as stocks or crypto or whatever else I might invest in.

5. Compound Growth v Linear Growth

If something grows linearly (straight up) then eventually it hits a ceiling where further growth becomes impossible due to physical constraints like building taller skyscrapers than exist today (for instance). Compound growth can continue forever without physical limits imposed on linear growth

AI James Altucher