Compounding of interest is the process that produces compound interest: each time interest is credited, it is added to the balance, so the next interest calculation is made on a larger sum. The main entry gives the formula, a worked example and the rules on disclosure.
Frequency and its effect
The phrase is often used when the focus is on how often interest is added, known as the compounding frequency. Interest may be compounded annually, quarterly, monthly, daily or, in theory, continuously. The more often it is compounded, the higher the effective return for a given stated rate, although the extra gain becomes very small beyond daily compounding. Banks in the United States show this effect through the annual percentage yield (APY), which includes compounding, while a nominal rate does not.
Compounding is set against simple interest, where interest is calculated only on the original principal and is not added to the balance. Over a year or two the difference is small; over decades it is large. That is why compounding is central to retirement saving and long-term investing, and why unpaid balances on credit cards and other revolving debt can grow quickly.
A common shortcut for gauging the effect is the rule of 72: dividing 72 by the annual interest rate gives the approximate number of years a sum takes to double with annual compounding. The general idea of earning returns on earlier returns is covered in the entry on compounding.