Compounding refers to the rate at which money grows if you automatically reinvest all the profit you make in the same investment.
To help you understand the concept of compounding, we will use a simple example of a bank account that pays interest. A bank can pay you two kinds of interest: simple interest or compound interest.
Simple Interest Calculation
Suppose you have $1,000 in the bank that pays 10% simple interest per year for 10 years. Each year, you will earn $100 interest on your $1,000 investment (in the bank account) as calculated below:
Yearly Interest = Yearly Interest Percentage x Deposit Amount
Yearly Interest = 10% x $1,000 = .1 x $1,000 = $100
The yearly simple interest for the 10-year period is shown below:
As you can see, the total amount of simple interest earned in the 10-year period is $1,000. We calculated this amount by multiplying the yearly interest of 10% by the initial amount you deposited in your account (the principal balance of $1,000) and adding up the resulting products for the 10-year period. Since you get back your initial principal balance of $1,000, you will receive a total of $2,000 at the end of the 10-year period. Remember that this simple interest method shown in the example above assumes that your yearly profit of $100 is not reinvested into the account.
Compound Interest Calculation
If the bank tells you that you will earn 10% yearly compound interest on your deposit (instead of 10% simple interest), you will make more on your investment than in the simple interest case. Once again, on a yearly basis, you will be earning 10% profit on your principal. But the difference in this case is that your yearly profit (i.e. your yearly interest) will be reinvested each year into the bank account, and not taken out, as was the case with the simple interest calculation above. Here is how your money will stack up each year with compound interest: