What is Compounding?

In finance and investing, compounding is the act of reinvesting your profits so that they can make additional profit. Compounding is often discussed in the context of compound interest on savings accounts or mutual funds. Understanding whether your investment pays simple or compound interest can make a huge difference in the amount of money your investments or savings earn.

Financial institutions may compound interest, daily, monthly or yearly. In the simplest terms, imagine that you drop $1000 US Dollars (USD) in a savings account that earns 5% interest compounded yearly. The first year, you would earn $50 USD on your initial investment. As long as you kept that money in place, the next year, you’d earn five percent of $1050 USD, $52.50 USD. In two years, since your investment was compounding, your investment would now be worth $1102.50.

When your investment is not compounding, you are earning what is called simple interest, only the interest on the initial investment. Instead of your profits rising each year, your profit remains stable. Each year you’d make $50 USD on your investment of $1000 dollars. In four years your account value would be $1200 USD. However if the bank compounds the interest on yearly basis, your account value in four years would stand at $1215.51 USD. The longer interest is allowed to compound, and the number of times it is compounded means your investment will grow more significantly than if you were merely making simple interest. Reinvesting profits, when interest remains stable, is a great way to make more money through investments.

There is actually a fairly simple formula for figuring out how much you will make when interest is compounding. The formula is:

I = p(1 + interest rate)^y

In translation, this means compound interest (I) is equal to the interest rate plus 1, raised to the number of years (y) interest is compounded, and multiplied to the principal investment (p). If interest is compounded more than once yearly, the formula is nearly the same, and looks like this:

I = p(1 + interest rate)^yt

The main difference here is that the exponent y(number of years), is multiplied times the number of times per year (t) that an investment is compounded. Note that if your initial investment of $1000 USD was compounded daily, in four years time you’d have $1221.39.

The formula for compounding interest can get a bit complicated, especially when the number of times interest is compounded per year increases, and as the number of years you allow an investment to sit increases. The good news is that the Internet has a variety of compound interest calculators that will figure this for you, if you don’t happen to have a scientific calculator on hand.

It’s not only important to understand compounding from an investment perspective but also to understand it when you borrow money. Credit cards, home loans, auto loans, and the like may compound your interest. In this case, you want to find loans where interest is compounded the least amount of times, since you will tend to pay more. Furthermore, some loans charge all interest on a loan upfront. This is true of many auto loans. You may end up paying several years of interest payments before you really start making inroads into payments on the principal of your car. Some loan companies will allow you to make additional payments to the principal, which can help reduce the overall amount of interest you will pay.

As an investor, the more times your interest compounds, the greater your profit. This is usually only the case as long as you allow the profit to be reinvested, so that interest is earned on both principal and profit. If you remove all profits from the investment, then you’re really only making simple interest on the amount invested.