Investors may often wonder what the difference between compounding and compound interest is, so this article will give you all the information you need.
Oct. 16, 2023
Being able to use compound interest to your advantage is a powerful tool and it can help you reach your financial goals at a faster rate.
And you can now learn all about this through our compound interest calculator, which shows you exactly what the magic of compounding can do.
Definition of compound interest
Compound interest is the interest on a deposit or a loan that takes into account both your initial principal and the interest this sum has accumulated over previous periods. As you are not just earning interest on the principal amount every period but on the cumulative sum, you will be getting more bang for your buck.
For example, take a savings account that contains $10,000 and earns 2% compound interest each year.
- After year 1, you will have $10,200 in your account ($10,000 principal + 2% of $10,000)
- After year 2, you will have $10,404 in your account ($10,200 balance + 2% of $10,200)
- After year 3, you will have $10,612.08 in your account ($10,404 balance + 2% of $10,404)
After three years, your initial $10,000 principal has grown by $612.08
You can compare compound interest to simple interest using the same example, whereby the 2% interest is charged each year only on the principal sum.
- After year 1, you will have $10,200 in your account ($10,000 principal + 2% of $10,000)
- After year 2, you will have $10,400 in your account ($10,200 balance + 2% of $10,000)
- After year 3, you will have $10,600 in your account ($10,400 balance + 2% of $10,000)
After three years, your initial $10,000 principal has grown by $600.
So, what is compounding then?
Compounding is the process whereby the earnings of an asset, such as capital gains or dividends reinvested, lead to further earnings growth over time. The investment will continue to produce earnings from the principal and the earnings that have accumulated over the previous periods.
For example, reinvesting your cash dividends to buy more shares will compound your returns thanks to the future dividend payouts. Do note that compounding works for both assets and liabilities.
To calculate the future value of an investment through the compounding effect at a certain rate of return per period, you can use the following formula:
FV = PV x (1 + i)^n
- FV = Future Value
- PV = Present Value
- i = Rate of return/interest rate for the period
- n = number of periods per year
If you are investing $100,000 and you want to know what size your investment will be assuming an annual return of 8% that is compounding over 10 years, here is the solution using the above formula:
FV = $100,000 x (1 + 0.08)^10
FV = $215,892.50
Profit = $115,892.50
To showcase the true power of compounding, you can use the same example as above but apply a rate of 8% simple interest on the principal sum each year, with nothing able to be reinvested.
Profit = $100,000 x 0.08 x 10 = $80,000
As you can see, the difference in the gain between the two types of investments is significant. The gap is $35,892.50 after ten years, or 44.87% more when compounding rather than just receiving simple interest.
Once you have a well-balanced investment plan in place, you can harness the power of compound interest to greatly accelerate your journey toward your financial goals.
