The sooner you start contributing to an investment account, the better, thanks to the effect of compounding over time. Compounding is the process in which an asset’s earnings (either gains or interest) are reinvested to generate additional earnings over time.
This growth in earnings, which is calculated using exponential functions, occurs because an investment can generate earnings from the initial principal investment and from the accumulated investment gains and interest from preceding periods. Compounding is a motivating factor behind many investing strategies.
The magic of compounding allows interest to be earned on interest, which magnifies returns to interest over time. When bank or financial institutions credit compound interest, it could be based on one of several compounding periods, such as annual, monthly, or daily.
To show how compounding works, suppose $10,000 is held in account that pays 6% interest every year (annually). After the first year, the account balance will rise to $10,600, reflecting the $600 rise due to the interest added. In the second year, the account will realize 6% interest on the $10,600 balance, resulting in another $636 of interest, for a new total balance of $11,236. After 10 years, assuming a continued interest rate of 6% and no withdrawals, the account would grow to $17,908.48.
This can easily be calculated using the formula for future value:
- FV = PV x (1 + i)^ n
- PV = Present Value
- i = Annual interest rate
- n = Number of compounding periods per year
- FV = $10,000 x (1+0.06) ^ 10
- FV = $10,000 x (1.06) ^ 10
- FV = $10,000 x 1.790848
- FV = $17,908.48
The effects of compounding are magnified as the compounding frequency increases. Assuming a one-year time period, the more compounding periods throughout the year, the higher the future investment value.
To illustrate this, assume that an investment of $1,000,000 earns 10% per year. The future value at the end of the year increases as the number of compounding periods increases. The resulting future value, based on a variety of compounding periods, is:
- Annual compounding (n =1): FV = $1,000,000 x [1 + 10%/1] ^ (1 x 1) = $1,100,000
- Semi-annual compounding (n = 2): FV = $1,000,000 x [1 + 10%/2] ^ (2 x 1) = $1,102,500
- Quarterly compounding (n = 4): FV = $1,000,000 x [1 + 10%/4] ^ (4 x 1) = $1,103,812.89
- Monthly compounding (n = 12): FV = $1,000,000 x [1 + 10%/12] ^ (12 x 1) = $1,104,713.07
- Weekly compounding (n = 52): FV = $1,000,000 x [1 + 10%/52] ^ (52 x 1) = $1,105,064.79
- Daily compounding (n = 365): FV = $1,000,000 x [1 + 10%/365] ^ (365 x 1) = $1,105,155.78
Don’t delay, start saving and taking advantage of compounding today!
Check out some of my other posts on saving, making, and investing money:
- Why Should I Invest in an IRA?
- Which IRA is Right For Me – Traditional or Roth?
- 6 Things to Know About Bitcoing Before You Buy It
Disclaimer: This information is intended for educational purposes and is not tailored for the needs of any specific investor. It is important to conduct your own analysis and research before making any investment. It is recommended to independently research and verify or seek financial advice from a professional in connection with any information on this website before using it to make an investment decision or otherwise.