What Is Compounding?

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What Is Compounding?

Compounding is the process reinvesting an asset’s earnings, from either capital gains or interest, to generate additional earnings over time. This additional earning is generated because the investment will generate earnings from both the initial investment and the reinvested amount. Compounding typically refers to the increasing value of an asset due to the interest earned on both a principal and the accumulated Interest. Compounding is crucial to finance, and the gains attributable to its effects are the motivation behind many investing strategies.

How does Compounding Work? 

Suppose $100,000 is held in an account that pays 6% Interest Monthly. After the first Month, the total amount has become $106,000. In month 2, the account realises a 6% growth on both the Original Principal and the given interest of the first month, meaning, you have $112,360 invested by the end of the second Month. After the First Year, assuming there’s no withdrawals and the interest rate stays at 6% per month, the account would grow to $201,219.

What’s the formula for The Future Value on Compound Interest? 

The generalised formula for the Future Value of your current asset can be calculated using this formula. It takes into account the present value of your asset, the annual interest rate, and the frequency of compounding per year and the total number of years.

FV = PV x [1 + (i / n)] (n x t)

where:

  • FV = future value
  • PV = present value
  • i = the annual interest rate
  • n = the number of compounding periods per year
  • t = the number of years

For Example:

 

  • Annual compounding (n = 1): FV = $1,000,000 x [1 + (20%/1)] (1 x 1) = $1,200,000
  • Semi-annual compounding (n = 2): FV = $1,000,000 x [1 + (20%/2)] (2 x 1) = $1,210,000
  • Quarterly compounding (n = 4): FV = $1,000,000 x [1 + (20%/4)] (4 x 1) = $1,215,506
  • Monthly compounding (n = 12): FV = $1,000,000 x [1 + (20%/12)] (12 x 1) = $1,219,391
  • Weekly compounding (n = 52): FV = $1,000,000 x [1 + (20%/52)] (52 x 1) = $1,220,934
  • Daily compounding (n = 365): FV = $1,000,000 x [1 + (20%/365)] (365 x 1) = $1,221,336

When calculating compound interest, the number of compounding periods makes a significant difference. Generally, the higher the number of compounding periods, the greater the amount of compound interest.

The Bottom Line

Get the magic of compounding working for you by investing regularly. Familiarising yourself with the basic concepts of and compound interest will help you make better financial decisions, saving you thousands of dollars and boosting your net worth over time. To learn more about Investment and Compounding, Contact us and we’ll be more than happy to give you more info.

 

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