Compounding occurs when the money earned from investments is reinvested for the chance to gain even more. This concept allows employees saving for retirement to make money on their existing funds. Compound earnings come from the interest or dividends earned on an investment on top of any increase in the value of that asset. Compound interest relates to interest earned on instruments such as savings accounts, money markets and certificates of deposit.
Functions of Compound Earnings
Investors can incur compound earnings on instruments such as bonds, stock or real estate. As these assets increase in value, the owner can choose to sell them or collect other payments on them, such as bond interest payments or stock dividends. Asset holders can compound their earnings by reinvesting their returns back into the assets, rather than cashing out the payments. When the payments are reinvested, the amount of these payments is added to the investment, thus increasing its value.
Examples of Compound Earnings
A participant in a mutual fund sees in an investment report that the fund earned 20 percent over the last year, but the share price increased by only 16 percent over that time frame. The difference is that the fund issued two dividends of 2 percent each, for a total of 4 percent in dividend payments. The dividend payments plus the increase in share price accounts for the compound earnings shown in the fund report.
Functions of Compound Interest
Most people are familiar with the concept of simple interest, but very few understand the power of compound interest. With simple interest, the interest accumulates as a function of the principal. With compound interest, the interest adds as a function of both the principal and the previously accumulated interest. This "interest on interest" allows compound interest accounts to appreciate in value at an astounding rate.
Examples of Compound Interest
The formula for calculating annually compounded interest is the product of the principal times the interest rate to the power of the number of years the funds stay in the account. Say an investor places $10,000 in an interest-bearing account at a 5 percent interest rate compounded annually. At the end of Year 1, the account holds $10,500 ($10,000 x 1.05). At the end of Year 2, the account holds $11,025 ($10,000 x 1.05^2). By Year 10, the account holds $16,288.94 ($10,000 x 1.05^10). By Year 30, the account holds $43,219.42 ($10,000 x 1.05^30).
Video of the Day
- Goodshoot/Goodshoot/Getty Images