What is Compounding?
Compounding is a method of calculating total interest on the principal where the interest earned is reinvested. For the investors, it results in exponential growth of assets or capital.
Similarly, when compound interest is applied to liabilities like debt, it becomes a considerable burden for debtors. The principal amount can be compounded monthly, quarterly, annually, or even daily. Contemporarily, most investment vehicles yield compound interest.
Table of contents
Key Takeaways
- Compounding allows interest on the overall amount, i.e., the principal sum and the accumulated interest.
- The amount increases exponentially because the interest is not withdrawn; it is reinvested to generate additional returns.
- The compound interest provides a higher return than simple interest. The simple interest yields interest only on the principal sum.
- The compound interest formula is as follows:
- Compound Interest = Principal [(1 + rate of interest) ˄number of periods – 1].
How does compounding work?
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For eg:
Source: Compounding (wallstreetmojo.com)
Compounding considers the principal amount, the rate of interest, and the frequency of interest payments. In compound interestCompound InterestCompound interest is the interest charged on the sum of the principal amount and the total interest amassed on it so far. It plays a crucial role in generating higher rewards from an investment.read more also known as CI, the interest amount is reinvested—a multiplication effect is triggered. Therefore, over the years, compound interest growth is steeper than simple interestSimple InterestSimple interest (SI) refers to the percentage of interest charged or yielded on the principal sum for a specific period.read more. Simple interest only pays the same amount of interest every year.
The Continuous Compounding FormulaContinuous Compounding FormulaThe continuous compounding formula depicts the interest received when constant compounding is done for an infinite number of periods. The four variables used for its computation are the principal amount, time, interest rate and the number of the compounding period.read more can be applied to assets and liabilities as well. Investors earn maximum when the interest on assets gets compounded. The mutual fund is a good example of CI. Similarly, when CI is applied to liabilities like debt, it becomes a considerable burden for debtors. The impact of CI can be described as “making money out of money.”
Compounding Formula & Calculation
CI is the total interest on the principal earned—inclusive of the reinvested interest amount.
The compounding formula is as follows:
C=P [ (1+r)^{n} – 1 ]
Here C is the compound interest,
P is the principal amount,
r is the rate of interest,
n is the number of periods.
The calculation of CI involves the following steps:
- Ascertain the principal amount.
- Determine ‘r’; if the interest rate is given in percentage, convert it into decimal value by dividing it by 100. Also, if the annual rate of interest is available but compounding is done periodically, divide the decimal value by the number of periods.
- Next, determine n, if the compounding is done annually, then directly put the number of years of investment. But, if the compounding is done periodically, multiply the number of years by the number of periods. Remember, the interest can be compounded quarterlyCompounded QuarterlyThe compounding quarterly formula depicts the total interest an investor can earn on investment or financial product if the interest is payable quarterly and reinvested in the scheme. It considers the principal amount, quarterly compounded rate of interest and the number of periods for computation.read more. Alternatively, CI could be computed on a monthly, or weekly basis as well.
- Now that you have all the values, put these in the formula to determine the CI.
Examples
Let us look at some examples to better understand the practical application of the concept.
Example #1
Shane and Mark both decided to invest $100,000, but Shane opted for simple interest, and Mark went with CI. Both invested for ten years and received 10% interest. So, what will happen after ten years?
Solution:
Given below is the computation of Shane’s investment:
Shane’s total earnings = $200,000 after ten years.
Following is the calculation of Mark’s investment:
Mark’s total Earnings = $2,59,374
Due to CI, Mark makes $59,374 more than Shane—in the same number of years, at the same interest rate.
Example #2 (Weekly)
Simon saves $7500 for his son’s college fund—who will attend college after 15 years. Simon invests in US Savings Bonds. The annual coupon rate for the US saving bond is 6%. What is the Future Value of Simon’s money after 15 years if the amount is compounded weekly?
Solution:
Given,
Principal = $7500
Rate = 6% or 0.06
Time Period = 15 years.
Number of times the sum compounded in one year, n = 52 Weeks
Future value =?
The calculation of future value is as follows:
The Formula of Future ValueFormula Of Future ValueThe Future Value (FV) formula is a financial terminology used to calculate cash flow value at a futuristic date compared to the original receipt. The objective of the FV equation is to determine the future value of a prospective investment and whether the returns yield sufficient returns to factor in the time value of money.read more is applied to CI every week:
F = P(1+r/n) ^n*t
F = $7500(1+0.06/52) ^52*15
F = $7500(1+0.001153846) ^780
F = $18,437.45
Thus, by investing $7500, Simon will get a lumpsum amount of $18,437.45 in 15 years.
Example #3 (Effective Annualized Yield)
Let us assume XYZ limited bank provides a 10% interest every annum on fixed deposits—to senior citizens. We assume that CI is computed every quarter. Now, calculate the effective annualized yield for 5, 7, and 10 years.
Solution:
#1 A = Annualized Yield for 5 Years
t = 5 years
n = 4 (CI applied every quarter)
I = 10% per annum
So, A = (1+10%/100/4) ^ (5*4)
A = (1+0.025) ^20
A = 1.6386
I = 0.6386 in 5 Years
Effective Interest = 0.6386/5 = 12.772% per annum
#2 A = Annualized Yield for 7 Years
t = 7 years
n = 4 (CI applied every quarter)
I = 10% per annum
So, A = (1+10%/100/4) ^ (7*4)
A = (1+0.025) ^28
A = 1.9965
I = 1.9965 in 7 Years
Effective Interest = 0.9965/7 = 14.236% per annum
#3 A = Annualized Yield for 10 Years
t = 10 years
n = 4 (CI applied every quarter)
I = 10% per annum
So, A = (1+10%/100/4) ^ (10*4)
A = (1+0.025) ^40
A = 2.685
I = 1.685 in 10 Years
Effective Interest = 1.685/10 = 16.85% per annum
The above example shows the power of CI. Longer the investment horizonInvestment HorizonThe term "investment horizon" refers to the amount of time an investor is expected to hold an investment portfolio or a security before selling it. Depending on the need for funds and risk appetite, the investor may invest for a few days or hours to a few years or decades.read more, greater the exponential growthExponential GrowthExponential Growth refers to the increase due to compounding of the data over time and follows a curve representing an exponential function. Exponential growth formula: Final value = Initial value * (1 + Annual Growth Rate/No of Compounding ) No. of years * No. of compoundingread more.
Frequently Asked Questions (FAQs)
It is the power of multiplying the investor’s money. So, in the long run, the investor’s wealth increases exponentially. This is because the investor doesn’t withdraw the interest earned on the principal amount. The interest yield is reinvested.
The rule of 72 determines the number of years required for doubling the invested amount at a certain interest rate. It works well for ROIs between 6% and 10%.
The simple interest offers interest at a certain rate only. The principal is multiplied by the rate of interest and time, then divided by 100. In contrast, CI is the aggregate of interest yielded on the principal sum and the accumulated interest. It is the multiplication of principal amount with one plus interest rate to the power of n, minus the principal amount. Here “n,” denotes the number of periods.
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