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Compounding

Compounding refers to the process in which an investment generates earnings or interest that are reinvested to produce additional earnings. Over time, this creates a "snowball" effect, as the investment grows at an accelerating rate. The frequency of compounding, such as monthly or annually, affects the growth rate, with more frequent compounding leading to faster growth. Compounding is a fundamental principle in finance, used to maximize returns on investments and savings over time.

Example

A savings account with an interest rate of 4% compounded monthly will grow faster than one with the same rate compounded annually because the interest is added to the principal more frequently.

Key points

• Compounding is the process where earnings or interest on an investment generate additional earnings.

• The frequency of compounding affects the growth rate, with more frequent compounding leading to faster growth.

• Compounding is a key principle for maximizing investment returns over time.

Quick Answers to Curious Questions

Compounding is the process where earnings or interest on an investment generate more earnings, creating a snowball effect that accelerates growth over time.

The more frequently interest or earnings are compounded (monthly, quarterly, annually), the faster the investment grows, as interest is added to the principal more often.

Savings accounts, bonds, stocks with reinvested dividends, and any investment where returns are reinvested benefit from compounding.