Compounding is one of the most important concepts to master when investing in bonds. What is compounding? Compounding is earning interest on interest.
Lets say that you open an account for $10,000 that pays an annual interest rate of 10%. Assuming the account only pays interest once a year, and that you don’t deposit or withdraw any money during the year, you would have earned $1000 in interest at the end of the first year. After adding that $1000 in interest to your original balance of $10,000, your balance at the end of the year would be $11,000.
You keep $11,000 in your account for another year with the interest rate remaining at 10%. The total interest earned in year two would be $1100. As you can see, in year two you earned $100 more than you earned in year one. The different is the 10% interest you earned on the $1000 of interest from year 1. The additional interest earned in year two was earned without having to deposit any additional money into the account.
“Interest on interest” is commonly referred to as compound interest.
While $100 extra in “interest on interest” may not seem like a lot, this can make a huge difference over time. In the example above if you left the original $10,000 in the account, and continued to earn 10% each year for 20 years (including the original two), you would have $67,200. If compounding was left out of the equation in this example, and you continued to earn the same $1000 from year 1, in each of the subsequent years, you would only have $30,000 in your account at the end of the same 20 year period. As you can see from this example, without compounding you earned 2 times your money in interest. With compounding you earned close to 6 times. This shows that in addition to the rate of interest you earn, the longer the time horizon that you invest, the bigger the impact of compounding.
Most investments do not wait until the end of the year to pay interest. With savings, checking and money market accounts it is not unusual to see accounts that pay interest monthly, or even daily. The greater the frequency of payments (with the best being daily compounding), the better the outcome.
To illustrate, there are two identical accounts with $10,000. One which pays interest quarterly and the other which pays annually. The interest rate is 12%.
With the account that compounds annually, you would receive $11,200 a the end of the year. ($10,000 + ($10,000 x 0.12)
With the account the compounded monthly, you would have $11,255.04 or $55.04 more than than the account that compounded annually. ($10,000 + $10,000 x.03) x 1.03 x .1.03 x.1.03
With this in mind it is important to understand not only how much interest an investment pays, but also how and when interest is paid.