Compounding is when the earnings from an investment (e.g., interest on a bond or certificate of deposit) are
added to your original investment pile, and those earnings then build upon themselves. Here’s how it works:
Suppose you invest
$5,000
in a five-year CD paying 5% per year, with no compounding, and you
make no additional contributions along the way. You would earn $250 per year, and your $5,000 would become
$6,250
. Not bad, but if your interest compounded annually, you’d get $250 the first year,
then $262.50, $275.62, $289.40, and $303.87 for a grand total of $6,381.41 at maturity.
Use the calculator to play around with the inputs. Change the compounding frequency from annually to monthly,
and it’s
$6,416.79
. Raise the interest rate to 6%, and get
$6,744.25
.
But here’s where it gets interesting. Suppose you contribute that same $5,000 each year throughout a 40-year
career. That pile, compounded annually at 6%, would grow to
$825,238.42
. The earlier you
start, the more interest you’ll earn on your interest.