What Is Investment Compounding? All You Need To Know
Compounding or compound interest is the most important ratio or financial concept on how to value interest on your investment, if you have been asking the question “what is Investment Compounding?” this article is for you.
Investment Compounding could give you an answer to your question of “how do I make money from an investment?” or “how do I make money using money?”. You might recall learning compound interest in school.
What is interest?
Interest is what you earn as a reward for lending your money or work done. For example, you pay interest at the rate fixed by the bank when you take a loan. Similarly, the bank pays you interest for your deposit in the bank account, which they use to make investments or lend to other customers.
In general, there are two types of calculating interest; Simple and Compound. Let us understand the difference to learn about compounding better.
What is the difference between simple and compound?
In simple interest, the interest on your deposit is only calculated on the base principal amount that you must have invested. In case of compounding the interest that you earn in the first period is added to the principal and taken as a base for further evaluation.
We shall take 10,000 as the principal amount and 10% of the rate of interest per annum to keep it
simple. In this example, let us also assume that the amount was never withdrawn in the given five years and interest was computed annually.
| Years | Simple | Balance at the end of the year | Compound | Balance at the end of the year |
| 1st Year | 1000 | 1000 | 1000 | 11000 |
| 2nd Year | 1000 | 12000 | 1100 | 12100 |
| 3rd Year | 1000 | 13000 | 1210 | 13310 |
| 4th Year | 1000 | 14000 | 1331 | 14641 |
| 5th Year | 1000 | 15000 | 1464.1 | 16105.1 |
As you can see in the table above, the rate of interest is the same for the first year in both methods. The change occurs in the second year when the base for interest calculation remains 10,000 for simple interest but changes to 11,000 for compounding.
Compounding Formula
The above example was an ideal situation that required basic calculations. But what if you want to calculate how much you will earn on your investment based on the fact that interest will be computed more often than once a year. You could use the formula A=P(1 + r/n)^nt.
Here,
A: the future amount you will receive
P: the amount you will be investing
r: rate of return
n: number of times the interest will be compounded in a year
t: number of years you plan to keep your money invested.
Compounding in Investment
If you were to invest 10,000 with an annual return of 10%, using the above formula, in 10 years you will get:
10,000 (1 + 0.10/1)^(1 x 10)
=10,000 (1+0.10)^(10)
=10,000 (1.10)^10
=10,000 (2.594)
=25937. 42
So in ten years, you will have gained 15937 (rounded off) in addition to the 10,000. Whereas, in case of simple interest you would have made just 10,000 more ( 1000 x 10 years). With this, I believe I have been able to teach you on how to calculate the money you invest to get more money.
