Somewhere Einstein is quoted as saying that the greatest force in the world is compound interest. I’m not sure if he said it, but it is a deep truth, and people like to tie Einstein’s name to things to make it seem real and important, even if they only know him as the eccentric genius of the later years where he traded on the reputation he made in a couple of papers in his youth – but I digress.
Compounding is where you take a sum of money and apply interest to the amount of money that is also earning interest. So for example, in a simple interest scenario, if you have $1000 bucks at ten percent interest for ten years, you get ten periods where you get 100 bucks, and you double your money in real terms over those ten years. But with compounding, you take a thousand bucks, and at the end of year one, you get a hundred bucks, so that at the start of year two, you are actually earning interest on the original thousand plus the new hundred bucks. This means that with compounding only one time a year, at the end of the ten years, you will end up with $2,593.74, more than doubling the original investment. Discounting is basically the opposite of compounding. If you need a certain amount of money in the future, you need a smaller amount than the amount you need because the magic of compounding .