Compounding, also known as interest upon interest, is a system that calculates interest or capital gains on an investment based on the capital AND the interest. This is as opposed to linear or simple interest. Linear or simple interest calculates the interest on an investment based solely on the capital. That means the interest is calculated on a constant principal at the beginning of each period for a preset duration. However, in the case of compounding, the interest from the previous period is added to the principal from that preceding period to make the principal for the new period. Thus, the principal is constantly increasing at the beginning of each period till the preset duration runs out. This also corresponds with an increase in profits as well.
The periods in compounding could be annual, monthly, weekly, or daily. However, it’s very common to find periods expressed per annum as compounding tends to be especially popular amongst long term investors. Compounding can also be used by financial institutions or persons to determine repayment of loans. This makes the amount to be repaid a lot more than the amount borrowed. So basically, the advantage of compounding is its disadvantage, depending on the side of the agreement you are on.
Summarily, compounding is a strategy that increases the principal of each period compared to the preceding one in an investment duration by adding the interest and principal of the preceding period together to make up the principal of the new period. It’s a strategy you want to try out if you’re looking to maximize your profits from an investment. However, it requires a high level of discipline and commitment to the plan.
