Compounding is the process wherein interest is added to the principal so that the interest itself also earns interest. This kind of interest is called compound interest. In the world of finance compound interest is the norm, though in some rare cases, simple interest (non-compounding) is applied.
Compounding is considered to be a double-edged sword. It can work for you when used to grow your savings and investments. It will work against you, however, when it comes to debts. In fact, compound interest is considered to be so powerful that even Albert Einstein is quoted to have said that “The power of compounding was said to be deemed the eighth wonder of the world – or so the story goes.”
Here is an example of how compounding works. Say you invest $1000 into stocks at the beginning of the year. Your stocks rise by 10% by the end of the year. The $100 you earn from interest will be added to your total investment portfolio so that next year, you will have $1100 invested. This entire $1100 will then earn interest. If the stocks rise by 10% again the next year, you will be earning $110 in interest of just $100, which again will be added to the principal for a total of $1210. If this interest rate continues, by the end of the fifth year, you will have $1610.51 instead of just $1500, which means that the interest helped you earn an additional $110.51 in 5 years.