How compounding works

What does compounding mean?

Simple interest pays you only on the amount you started with. Compounding pays you on the starting amount plus whatever has already been added. Leave the earlier return in place, and the next return is calculated on a larger pile. Take the earlier return out and spend it, and there is nothing extra to earn on.

The idea shows up in savings, in treasury bills you roll into a new bill, and in shares, if dividends buy more shares or the business reinvests its profit. None of them is automatic.

What does a made-up example look like in cedis?

Start with GH₵2,000. Pretend it grows by 10% a year (a made-up rate) and that you leave every cedi in place.

• Start: GH₵2,000
• After year 1: GH₵2,200
• After year 2: GH₵2,420
• After year 3: GH₵2,662

Simple interest at the same made-up 10% would add GH₵200 a year and finish at GH₵2,600. The extra GH₵62 is the return on the earlier returns. Year 2 added GH₵220, not GH₵200, because the GH₵200 from year 1 was still there. That is the whole trick.

Losses can stack too. A fall, a fee or a withdrawal breaks the pattern, and real returns do not arrive at the same rate every year.

Why is a bigger number of cedis not always more wealth?

Prices in Ghana move. A larger balance later can buy less kenkey, less fuel or less schooling than a smaller balance bought a few years earlier, if prices rose faster than the balance. The Ghana Statistical Service publishes consumer prices. Check the latest figure and its date.

When you compare a return with prices, use the same period. A one-year bill and a ten-year story about prices are not the same comparison.

Do you need a large amount to start?

No. The maths works on any amount. Time and the rate both matter, and no one can promise the rate.

For the basics, read Treasury bills in Ghana and What is a stock?.

Where does this lesson get its numbers?

• The 10% and the GH₵2,000 are made up for the arithmetic.
• For prices, use the Ghana Statistical Service.