Compounding (Definition, Meaning) | Examples of Power of Compounding

Compounding Definition

Compounding is the method of computing interest rate which is effectively interest on interest where interest is calculated on investment/initial principal plus interest earned and other reinvestments, in other words interest earned is accumulated to the principal amount depending on the time period of deposit or loan that can be monthly, quarterly or annually

Below examples of compounding helps to understand how compounding methods work and outline the potential power of compounding methods. It shows how it is beneficial, and longer the investment horizon the greater is the exponential growth. Let’s try to understand what is compounding and how it’s work through some basic examples

Top 4 Examples of Power of Compounding

Let’s see some examples of the power of compounding to understand it better.

You can download this Compounding Examples Excel Template here – Compounding Examples Excel Template

Compounding Example #1

Two friends Shane and Mark both decided to invest $1,00,000, but Shane decided to invest in simple interest whereas Mark invests in compound interest for 10 years at 10% interest. Let see what happens after 10 years.

Solution:

So, the calculation of Shane investment will be –

Total Earning Amount = $200,000

With a Simple interest, Shane will get $2,00,000 after 10 years

The calculation of mark investment will be –

Total Earning Amount = $2,59,374

With Compound interest Mark investment values will grow to $2,59,374.

Now Shane decided to invest through compounding methods like Mark, and they both invested $2,00,000 at the rate of 15%.

The calculation of Shane investment will be –

Total Earning Amount = $8,09,111.55

Shane stays invested for 10 years and gets the final amount as $8,09,111.55 at the rate of 15%.

The calculation of mark investment will be –

Total Earning Amount = $65,83,790.52

However, Mark is patience long-term investors and stays invested for 25 years and his investment value grows to $65,83,790.52

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The above example shows the power of compounding, longer the investment horizon the greater is the exponential growth.

Compounding Example #2 (Weekly Compounding)

Simon is having $7500 in savings and for his son’s college fund who will be going to attend the college after 15 years, he decided to invest in US Savings Bonds. Simon’s goal is to save $20,000 and the annual percentage rate for a US saving bond is 6%. What is the Future Value of Simon Money after 15 years?

Solution:

Given,

Principal = $7500
Rate = 6% or 0.06
Time Period = 15 years
How many times it’s compounded in a year n = 52 Weeks
Future Value =?

So, the calculation of future value will be –

The formula for weekly compounding is as below.

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

So from above calculation it is clear that Simon goal of to save $20,00 will not get achieved with above methods but it’s closer to that.

Continuous Compounding Method –

Now let’s try the above example with Continuous Compounding Formula.

So, the calculation of future value will be –

F = Pe^r*t

F = $7500e^0.06*15
F = $7500e^0.9
Future Value (F)= $18,447.02

Now even with Continuous Compounding Simon goal of savings $20,000 for his son’s college fund will not be achieved.

Let’s see with Monthly compounded Formula that how much money did Simon need to invest to achieve his goal of saving $20,000 in 15 years at with APR of 6%?

So, the calculation of future value will be –

F = P(1+r/n)^n*t

$20,000 = P(1+0.06/12)^12*15
P = $20,000/(1+0.06/12)^12*15
Principal (P) = 8149.65

So by Solving the above equation will get an answer that is $8,149.65 (Amount which Simon needs to invest to achieve his goal of saving $20,000 in 15 years).

Compounding Example #3 (Effective Annualized Yield)

Let’s Say XYZ limited bank gives 10% per annum to Senior citizens for fixed deposit, and we assume here that bank interest is quarterly compounded like all other banks. Calculate the effective annualized yield for 5, 7 and 10 years.

Solution:

Annualized Yield for 5 Years:

t = 5 years
n = 4 (quarterly compounded)
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

Effective I = 12.772% Per Annum

Annualized Yield for 7 Years:

t = 7 years
n = 4 (quarterly compounded)
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 I = 0.9965/7

Effective I = 14.236% Per Annum

Annualized Yield for 10 Years:

t = 10 years
n = 4 (quarterly compounded)
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 I = 1.685/10

Effective I = 16.85% Per Annum

Compounding Example #4 – (Annuities: Future Value)

$1,000 is invested every 3 months at 4.8% per annum compounded quarterly. How much will the Annuity be worth in 10 years?

Solution:

So when we say how much will the Annuity be worth in 10 years means here we have to find future value and this important because whenever there is an example on annuities we have to see what we have to find out.

So, the formula of Future Value is

FV of Annuity = P [ (1+ r)ⁿ – 1 / r ]

P = Periodic Payment
r = Rate per period
n = Number of periods

So the formula of Future Value is

So here P = $1,000
r = 4.8% Per Annum or 0.048
r (quarterly) = 0.048/4
r (quarterly) = 0.012
n = 10 years
n (Number of times compounding will apply) = 10×4 =40

So, the calculation of FV of Annuity will be –

So now FV = $1000[1+0.012]^40 -1/0.012]

So by Solving the above equation will get an FV as $50,955.30

So how much will be the Annuity in 10 years and answer is $50,955.30

As additionally, we can also find out from the above example that how much interest is earned in 10 years.

As 40 times $1000 is invested that is a total investment (40×$1000 = $40,000).

So Interest = Future Value – Total investment

Interest = $50,955.30 – $40,000
Interest = $10,955.30

So here it is important to understand that in Annuities investors can earn a lot of interest, in the above particular examples a deposit of $40,000 gives in return total interest of $10,955.30.

Note: You can download the Excel template provided Above for detailed calculation.

Conclusion

So the above examples show the power of the compounding method and how it helps to increase the value of assets by earning interest on both principal and accumulated interested. The first example above shows how investors can earn more money through compounding instead of simple interest method, and it tells us that patience is required to earn a higher return. The second example shows how investors can make a decision of investment by applying different methods of compounding that is Monthly, Weekly, quarterly and so on.

Compounding methods also used to compare effective Annualized Yield for different years. Example four shows how it makes investors Happy by providing a higher interest return amount at the maturity of the principal. Most of the investor’s wealth is comes from compounding interest so, it important to understand the concept of compounding.