Question

In 500 words or more, discuss the power and importance of compounding interest. Provide real-life examples of compounding interest applications.

Answer 1

Compounding happens when the interest/dividend you receive
on your investment is reinvested at the same rate.
The following are two examples:
1) If you have $1000000 in a fixed deposit paying 6% interest rate, and you
reinvest the interest payments in the fixed deposit.
You will have 1000000*((1.06)^20) in 20 years as opposed to not reinvesting
the interest payments.
In other words, you will have $3207135 in 20 years.
2) If you own a mutual fund that pays a dividend every year. You can choose
to reinvest the dividends in the mutual fund.
There will be capital gains on the mutual fund. In addition, you can reinvest
the dividend in the mutual fund. When you reinvest the dividend in the mutual fund, the mutual fund will
generate higher returns over the years. As the years go on, the mutual fund will become bigger
with the reinvestment of dividend. Furthermore, the bigger the mutual fund, the bigger will be the
annual return.