Compounding
The term compounding refers to the process of gaining interest on interest. While usually, interest is credited to the existing principal amount, compounding makes it possible to credit interest on the interest already paid.
With this growth calculated through exponential functions, the investment generates earnings from its principal and the accumulated earnings from preceding periods. In other words, an asset’s earnings don’t only come from capital gains but the interest as well. The simplest compounding definition is to build interest on interest by magnifying returns to interest in time. In the financial world, compounding is also referred to as the “miracle of compounding”.
How does Compounding Work?
Compounding works by increasing the value of an asset through interest gained on both the principal and the accumulated interest. This direct realization of the time value of money concept (TVM) can also be referred to as compound interest.
So that this concept is treated fairly, compounding works for both assets and liabilities. We already mentioned how compounding could boost an asset’s value in a shorter period of time. Going on the same principle, compounding can also increase the amount of money owned by someone in a loan. This happens as interest can accumulate in case of unpaid principal and previous interest charges.
Example of Compounding
Let’s say $20,000 is held in a bank account with a 5% annual interest. Once the first year passes, compounding will transform the total value to $21,000 based on the 5% interest rate. After the second year, however, compounding won’t only add another $1,000 to the account. Still, it will also add an additional $50 for the interest gained on the $1,000 interest from the previous year.
Popular Real Estate Terms
To sign a note on behalf of another individual and, therefore, to guarantee payment. The cosigner is responsible for the loan if the borrower defaults. Such an agreement may occur in ...
The amount of a periodic payment, whether monthly, quarterly, or annually, including interest and principal, required for a mortgage payment. ...
Also called a teaser. The starting interest rate of an adjustable rate loan. It generally lasts between 1 and 12 months, at which time the loan rate increases based on prearranged criteria. ...
mortgage being reduced through periodic principal and interest payments. ...
Situation where a neighbor hood is gradually occupied by progressively lower income people. ...
Reference to let the vendor beware. Without specific exemptions, the vendor is obligated for action by the buyer for any explicit or implied modifications in the contract or warranty. ...
Property description contained in a title deed. A deed description is intended to inform a reasonable person where property is located. It can be described by metes and bounds, by ...
An adversary hearing allows both parties to an issue to present their views. A public procedure performed by an administrative or legislative body to investigate certain matters and ...
Investments, usually in limited partnership, that can protect of defer shelter) part of the income from current taxes. Under current law, passive leases can be applied up to passive income. ...

Have a question or comment?
We're here to help.