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”.
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.
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.