Compounding is the practise of reinvesting an asset’s profits, whether they be from capital gains or interest, to create more earnings over time. Because the investment will create revenues from both its initial capital and the cumulative earnings from previous periods, its growth is computed using exponential functions. As a result, compounding varies from linear growth, Each period, just the principle earns interest.
You may have heard about the magic of compounding. But what exactly is compounding?
Compounding refers to growth in the capital value of an investment by reinvesting any earnings back into the investment itself. Unlike simple-return investments, where a certain amount is added to the principle value at the end of each period, and at the end of term you get back the capital, in compounded investments you earn interest on the interest too. This magnifies the return you can earn.
t means money getting multiplied/ interest on the interest. It is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.
When you chose this, the Principal + return from the first year become the principal for the second year, and that the Principal + return from the second year become the Principal for the third year and so on.
Let’s say you begin investing at age 25, putting Rs.200 a month in a tax-deferred retirement plan earning 9%. Your friend starts investing in the same plan at 45, but puts away twice as much money as you – Rs.400 a month.
At age 65, you will both have invested a total of Rs.96,000, but your investment would have grown to Rs.884,000, while your friend’s investment would be worth only Rs.268,000. The reason your investment has grown so much more than your friend’s – even though you both invested the same amount of money – is because of 20 extra years of compounding.