Have you ever heard of the term ‘compounding’, but you are not sure what it is and how it works exactly? Whether you are into finance or not, you must be aware of this term since you will often hear it.
So, what is compounding exactly? Compounding is a term that refers to the process in which an asset’s earnings from interest or capital gains are being reinvested to generate additional revenues over some time.
With the help of exponential functions, you can calculate this growth which happens since investment will generate earnings from its accumulated earnings and initial principle from linear growth. But have in mind that only the principal earns interest each period.
Have you ever thought about what compounding means in terms of forex?
What is compounding a forex account?
The compounding in forex, or in other words compounding in a forex account, describes a technique in money management that allows you to take the money you had made in profit so that you can invest it in more weight. You will build trading capital over time in a very high profitable way.
Indeed, this technique requires much time, effort, and dedication for you to master it in the best possible way. Nevertheless, once you master it, you’ll experience many benefits.
How does compounding interest work exactly?
Compounding interest is the term that refers to interest on deposit or loan that are both calculated based on an accumulated interest and initial principal from previous periods. In other words, it is ‘an interest on interest’, which makes a sum grow at a faster rate in comparison to simple interest. The calculation of it is made on the principal amounts.
The frequency of compounding affects the rate at which compound interest occurs. It means the following – the greater compound interest correlates with, the higher the number of compounding periods.
How can you calculate the compound interest?
To calculate the compound interest, you need to multiply the initial principal amount by one plus the annual interest rate, which is raised to the compound period’s number minus one. The total amount of the loan then gets subtracted from the resulting value.
Here’s the formula of compound interest.
The formula of calculating compound interest
- = [P (1 + i)n] – P
- = P [(1 + i)n – 1]
P is for principal, i is for the nominal annual interest rate in %, while n is the number of compounding periods.
The simple example of compounding
In finance, compounding is crucial, and its effects are the primary motivation for which many investing strategies are being made.
Here is one example – numerous corporations offer dividend reinvestment plans that enable investors to reinvest their cash dividends to buy additional stock shares. Reinvesting compound investor funds in this case since the increased number of claims will consistently increase future income from dividend payouts.
Conclusion – Key takeaways of compounding
In conclusion, there are a few things you need to remember regarding compounding:
- Compounding is the process where interest is credited to an interest already paid. It is also credited to an existing principal amount.
- It is considered as interest on interest refers to the effect of magnifying returns to welfare over time.
- Compounding annual, monthly, or daily period is used when financial institutions or banks credit compound interest.