Compounding

What Is Compounding?

Compounding is the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time. This growth, calculated using exponential functions, occurs because the investment will generate earnings from both its initial principal and the accumulated earnings from preceding periods.

Compounding, therefore, differs from linear growth, where only the principal earns interest each period.

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Key Takeaways

  • Compounding is the process whereby interest is credited to an existing principal amount as well as to interest already paid.
  • Compounding thus can be construed as interest on interest—the effect of which is to magnify returns to interest over time, the so-called “miracle of compounding.”
  • When banks or financial institutions credit compound interest, they will use a compounding period such as annual, monthly, or daily.
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Compounding: My Favorite Term

Understanding Compounding

Compounding typically refers to the increasing value of an asset due to the interest earned on both a principal and accumulated interest. This phenomenon, which is a direct realization of the time value of money (TMV) concept, is also known as compound interest. 

Compound interest works on both assets and liabilities. While compounding boosts the value of an asset more rapidly, it can also increase the amount of money owed on a loan, as interest accumulates on the unpaid principal and previous interest charges.

To illustrate how compounding works, suppose $10,000 is held in an account that pays 5% interest annually. After the first year or compounding period, the total in the account has risen to $10,500, a simple reflection of $500 in interest being added to the $10,000 principal. In year two, the account realizes 5% growth on both the original principal and the $500 of first-year interest, resulting in a second-year gain of $525 and a balance of $11,025. After 10 years, assuming no withdrawals and a steady 5% interest rate, the account would grow to $16,288.95.

Special Considerations

The formula for the future value (FV) of a current asset relies on the concept of compound interest. It takes into account the present value of an asset, the annual interest rate, the frequency of compounding (or the number of compounding periods) per year, and the total number of years. The generalized formula for compound interest is:

F V = P V × ( 1 + i ) n where: F V = Future value P V = Present value i = Annual interest rate n = Number of compounding periods per year \begin{aligned}&FV=PV\times(1+i)^n\\&\textbf{where:}\\&FV=\text{Future value}\\&PV=\text{Present value}\\&i=\text{Annual interest rate}\\&n=\text{Number of compounding periods per year}\end{aligned} FV=PV×(1+i)nwhere:FV=Future valuePV=Present valuei=Annual interest raten=Number of compounding periods per year

Increased Compounding Periods

The effects of compounding strengthen as the frequency of compounding increases. Assume a one-year time period. The more compounding periods throughout this one year, the higher the future value of the investment, so naturally, two compounding periods per year are better than one, and four compounding periods per year are better than two.

To illustrate this effect, consider the following example given the above formula. Assume that an investment of $1 million earns 20% per year. The resulting future value, based on a varying number of compounding periods, is:

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

As evident, the future value increases by a smaller margin even as the number of compounding periods per year increases significantly. The frequency of compounding over a set length of time has a limited effect on an investment’s growth. This limit, based on calculus, is known as continuous compounding and can be calculated using the formula:

F V = P × e r t where: e = Irrational number 2.7183 r = Interest rate t = Time \begin{aligned}&FV=P\times e^{rt}\\&\textbf{where:}\\&e=\text{Irrational number 2.7183}\\&r=\text{Interest rate}\\&t=\text{Time}\end{aligned} FV=P×ertwhere:e=Irrational number 2.7183r=Interest ratet=Time

In the above example, the future value with continuous compounding equals: FV = $1,000,000 × 2.7183 (0.2 x 1) = $1,221,403.

Example of Compounding

Compounding is crucial in finance, and the gains attributable to its effects are the motivation behind many investing strategies. For example, many corporations offer dividend reinvestment plans (DRIPs) that allow investors to reinvest their cash dividends to purchase additional shares of stock. Reinvesting in more of these dividend-paying shares compounds investor returns because the increased number of shares will consistently increase future income from dividend payouts, assuming steady dividends.

Investing in dividend growth stocks on top of reinvesting dividends adds another layer of compounding to this strategy that some investors refer to as double compounding. In this case, not only are dividends being reinvested to buy more shares, but these dividend growth stocks are also increasing their per-share payouts.

What is the Rule of 72 with compound interest?

The Rule of 72 is a heuristic used to estimate how long an investment or savings will double in value if there is compound interest (or compounding returns). The rule states that the number of years it will take to double is 72 divided by the interest rate. So, if the interest rate is 5% with compounding, it would take around 14 years and five months to double.

What is the difference between simple interest and compound interest?

Simple interest pays interest only on the amount of principal invested or deposited. For instance, if $1,000 is deposited with 5% simple interest, it would earn $50 each year. Compound interest, however, pays “interest on interest,” so in the first year, you would receive $50, but in the second year, you would receive $52.5 ($1,050 × 0.05), and so on.

How can investors receive compounding returns?

In addition to compound interest, investors can receive compounding returns by reinvesting dividends. This means taking the cash received from dividend payments to purchase additional shares in the company—which will, themselves, pay out dividends in the future.

Which type of average is best suited to compounding?

There are different types of average (mean) calculations used in finance. When computing the average returns of an investment or savings account that has compounding, it is best to use the geometric average. In finance, this is sometimes known as the time-weighted average return or the compound annual growth rate (CAGR).

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