The rate of inflation in the United States is roughly 2.5% per year. This means that if your money is not making at least 2.5% per year; the value of your money is actually decreasing. Compounding interest of stocks is a way to beat banks that are only paying .01% on savings accounts right now.

**What is Compounding Interest?**

Compounding interest is the money that you are making on the interest of your stock. You are essentially making money on already previously made money. The easiest way to explain and go through compounding interest is through a stock that pays dividends.

**How it works. ** We are going to use British Petroleum (BP) in our example to show exactly how compounding interest works. At the end of the trading day this article was written, BP is going for 41.72 per share. They are currently paying a 5% dividend. For this example we are going to assume that we have 100 shares of BP.

100 Shares of BP has a value of $4,172. Each year they pay out a 5% dividend. This is broken down into quarters to be a 1.25% dividend per quarter. This means that each quarter we will receive a check for $52.15. We can either reinvest this dividend for more shares or take it in cash. The only way to receive the compounding interest is to reinvest the dividend.

If we reinvest the $52.15 we will receive another 1.25 shares of BP ($52.15 / $41.72). This will add to our existing shares and we will now have 101.25 shares of BP

**The Compounding**

Three more months go by and we are set to receive our next dividend. Instead of this dividend being for the 100 shares before, it will now be for the 101.25 shares we have. For this equation we are going to assume that the share price is the exact same as it was before. If we do the same equation as above we will receive (101.25)(41.72) X 1.25% = $52.80. As you can see, we have received 65 more cents with this dividend than we did before. This is the magic of compounding. We took our dividend from last time and reinvested it and are now receiving more dividends from the past dividends. These dividends are compounding. While 65 cents may not seem like a big deal, we have only done 2 dividends. If we use this calculator we can see the difference between long-term dividend reinvestment and long-term dividend cash payouts.

**Long-Term Reinvestment Vs. Cash**

For this experiment we will assume we are 25 years old and wanting to retire at 65. We therefore have 40 years for our investment to grow. This will be 160 or more dividend compounds based on quarterly compounding and unexpected dividends. Using the calculator above, we will see the difference between reinvesting the dividends and taking the cash checks. We will assume a standard 10% annual yield.

Starting Value: $10,000

Years: 40

Annual Yield: 10%

Monthly Contribution: $0

Dividend Yield: 5%

Dividends: Reinvested

Ending Value: $2,678,635.46

Starting Value: $10,000

Years: 40

Annual Yield: 10%

Monthly Contribution: $0

Dividend Yield: 5%

Dividends: Not-Reinvested

Ending Value: 452,592.56

As you can see, reinvesting the dividends gave us 6 times as much ending value.

**Conclusion**

Compounding interest is an exponential process that gets significantly better the longer the money is left reinvesting. This is why it is recommended to start retiring as early as you can, max out your IRA yearly and maybe retire a couple years later than you originally intended. The data above shows the magic of compounding interest and why it is so valuable to reinvest your dividends and not take the cash. Use the calculator in this article and discover for yourself the importance of compounding interest.

*Related Articles:*

Why You Should Reinvest Dividends

Value Investing for Long-Term Investors

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