What is Compounding of Money?

Published by Thomas Herold in Accounting, Banking, Investments

'Compounding of Money' is explained in detail and with examples in the Accounting edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

The compounding of money has everything to do with compound interest. Compounding of money through such compounding interest can become among the most potent of weapons in your investing arsenal. Compound interest allows your money to grow at a faster rate as a result of the way that the interest is added to your money’s balance. Various types of compound interest are available for compounding your money.

Compounding your money with compound interest works through taking the interest that your money has earned over a time frame and adding it back to the initial amount of money. Then when the next period is figured up, this total dollar value is calculated in the next portion of interest that you will earn. Simply put, every time frame’s interest is placed directly back in to the entire sum of money on which the interest will be earned. Every time the interest is figured up, your money will earn a greater amount of interest like this.

A variety of different forms of compound interest exist. These always relate to the time frame over which the interest and money compounds. Such time frames of compounding of money are comprised of yearly, monthly, and daily compounding interest. With yearly compounding interest, the interest rate is figured up each year. In monthly compounding of interest, this rate is applied to the new principal balance each month. Daily compounding of interest involves an every day accounting of the interest and new principal.

Compounding of money involves several factors. These are periodic rates of compound interest, which are the rates actually applied to your balance, and compounding periods, which are the amount of the time frame before such interest is literally applied on to your total balance. As an example, if you invested $10,000 in a .1% daily periodic rate money market form of account, then on the second day, your balance would be $10,010. The next day, this rate would then be applied to the new balance of $10,010. Figuring out the actual annual effective rate entails you taking the whole year’s interest and dividing it by the amount of the investment that you started with at the beginning of the year, or $10,000 in this case.

Compounding of money through such compound interest proves to be an extremely potent weapon. This is because the interest earned is immediately added on to the account balance to be counted as principal for the next time period. Each time frame the interest rate applies to the greater balance. Accounts grow faster through the compounding of money as the interest is not held back.

This compounding of money effect multiplies when you use it with accounts that are tax deferred, such as municipal bond funds and annuities. As no penalties of taxes are paid in a given year, your money increases quicker and quicker since greater amounts are constantly in the account to receive interest.

An example of how effective compounding of money using compound interest can be is illuminating. If you put $10,000 into a simple interest account that does not compound but receives twelve percent interest, then it will increase to $46,000 over thirty years. The same money that is compounded annually will rise to about $300,000, and to as much as $347,000 if the money is compounded quarterly. Money that is compounded over a daily time frame would naturally earn the greatest amount of interest and highest principal over a period of time.

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The term 'Compounding of Money' is included in the Accounting edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.