Compounding

What Is Compounding?

Compounding is the process by which an investment's earnings are added back to its starting amount, so that future earnings are calculated on a larger base. Over time, this can cause a balance to grow at an increasing pace rather than in a straight line. The effect applies to interest earned on savings, to dividend payments that are reinvested, and to price gains on stocks that are held for many years.

How Compounding Works

With simple interest, earnings are calculated only on the original principal. With compounding, each period's earnings become part of the balance used to calculate the next period's earnings. The general formula for the future value of a compounded amount is:

Future value = Principal × (1 + r)^n

Here r is the rate of return per period and n is the number of periods.

As a hypothetical example, suppose $1,000 earns 10% per year, compounded annually. After the first year it grows to $1,100. In the second year, the 10% applies to $1,100 rather than $1,000, adding $110 instead of $100, which brings the balance to $1,210. After three years the balance reaches $1,331. Each year's gain is larger than the last because earlier gains stay invested. More frequent compounding, such as monthly rather than annually, produces slightly more growth at the same stated rate, which is why savings products are often compared using an annual percentage yield.

Why It Matters to Investors

Compounding rewards time. Because growth builds on previous growth, starting earlier and leaving money invested for longer often has a larger effect on the final balance than the size of any single contribution. This is one reason the time value of money concept is central to long-term planning.

Compounding works in both directions. Debts such as credit card balances can also compound, so unpaid interest is added to the amount owed and begins to earn interest itself. Losses compound too, since a decline reduces the base on which future growth is calculated. Compounded returns are never guaranteed, and the results of any investment depend on its actual performance, fees, and taxes.