Compounding is earning interest on the principal and on interest already earned; the longer the money is left in an account, the more dramatic the compounding effect.
With compounding, you earn interest on both the principal and the accumulated interest. Compounding is also known as compound interest.
You decide to open a savings account with an initial deposit of $100 on January 1st with an annual interest rate of 2%.
How much will you have in 3 years?
If the bank offered 2% interest, then at the end of Year 1 you would have $102 on December 31st. If you left the $102 for Year 2 you would have $104.04.
In this example, you earned interest on your initial $100 in Year 1, and you earned interest on the interest you’ve earned in Year 2. In Year 3, you would have $106.12.
If you had only earned interest on your original principal, and not on accrued interest, then you would have only $106 at the end of 3 years.
Now imagine how much compounding would grow if you started with a larger balance or made automatic deposits in an account with a higher interest rate and for a longer time period.