Whether you are an investor, financial manager, or just an average person who needs to learn a few things about the financial world, you will need to know what is compounding.
What Does the Term Compounding Mean?
When you invest, you will expect your investment to generate some earnings. These earnings can be from either interest or capital gains. When you re-invest these earnings, they will generate additional profit over time. Therefore, the process of re-investing profits to get more earnings is what is referred to as compounding.
When the initial investment profits are re-invested together with the earnings, you will get the compounded earnings. With time you will find that your investment is growing exponentially due to the gains you get in the succeeding periods. In linear growth, earnings gained from a particular investment period leave the initial investment (principal amount) to earn interest.
How Does Compounding Work?
Compounding can also be understood as the process of getting interest on top of earned interest. This effect tends to magnify the returns on interest during a given period. Therefore, since this happens after a given period, it becomes an aspect of the time value of money (TVM).
Compounding can work with both your liabilities as well as it does with assets. Compounding can boost your total assets value at a more rapid rate. However, it can also increase the amount of money that you owe on loan. This happens when you have interest piling on the unpaid loan, principal amount, and previous interest charges.
To illustrate how this concept works, we can take an example of an account that holds an initial amount of $10,000. Assuming that the account returns 5 percent annually, then the total amount in the account after the compounding period becomes $10 500. When this new amount stays in the account for another year, the 5 percent interest earned will be added to $500 together with the previous principal of $10 000. Therefore, in two years, the account will have gained a total of $525 in interest. The total amount in the account will become $11 025. If the initial principal and the subsequent earnings are retained in the account, the amount will grow at a 5 percent rate. Therefore, if the account were to run for ten years with no withdrawals and a steady 5 percent interest rate, the account balance would accumulate to a total of $16,288.95.
What to Consider When Compounding?
To get the future value of any of your current assets, you will need to calculate the asset’s compound interest in the future. Therefore, the future value of any of your current assets can be calculated from its present value. To make this possible, we can consider the interest rate gained in a particular period and the frequency of the compounding. This frequency is the number of compounding periods that your future takes into account. Luckily for you, the following is a formula that can help you calculate your current assets’ future value.
Breaking this formula apart, we obtain the following.
• FV – The future value of the current asset
• PV – The present value of the asset
• i – The interest rate during the compounding period
• n – The number of compounding periods in each year
• T – The number of years
What Is the Effect of Increasing the Compounding Periods?
If you increase the compounding periods, the effects become stronger with more returns on your investment. If we take one year, the compounding can be done daily, weekly, monthly, quarterly, semi-annually, or annually. This means that the more the compounding periods in a certain period, the more the returns you will get from an investment. Therefore, your investment’s future value will be bigger if you have two compounding periods in a year instead of one. Similarly, a daily compounding frequency will give you more returns than a monthly or quarterly compounding frequency.
To better understand this effect, using the above formula, we can calculate the future value of $1 million invested at a rate of 20% per year using various compounding periods as follows:
• Daily compounding: FV = $1m x [1+(20%/365)] (365×1) = $1,221,336
• Semi- annual compounding: FV= $1m x [1 + (20%/2)] (2×1) = $1, 200, 000
• Weekly compounding: FV = $1m x [1 + (20%/52)] (52×1) = $1, 220, 934
Looking at the above calculations, you find that a daily compounding gives better returns at the end of the year than a semi-annual and weekly compounding frequencies. Similarly, though the number of compounding periods in the year might increase significantly, the amount earned does not change significantly. This indicates that the compounding frequency in a set length of time does not affect your investment’s growth in a significant way. This limit is referred to as continuous compounding. To calculate the future value of an asset using the continuous compounding method, you can use the following formula:
FV = P x ert
In this formula:
• e – represents an irrational figure 2.7183
• r – is the rate at which the investment gains interest
• t – is the total compounding period
Using the above example:
FV = $1m x 2.71830.2 = $1, 221, 403
Where Can I Use Compounding?
You can use compounding in various ways, such as growing your savings, current assets, or evaluating how much loan you need if your creditor offers loans on compound interest terms. If you fail to understand the implications that compounding could have on a loan, you can end up accumulating very high charges and even a possible default. On the other hand, compounding can be a great way to grow your investment over time, which means business growth for business people and increased savings in your savings account.
Compounding can be a great tool to secure your investment and ensure that your savings are not dormant. It is also an excellent technique for growing the value of your business over time. If you are planning to start up a business, consider the utilization of compounding.