Compounding is the effect of interest earning interest upon itself. When a savings account or other investment earns compound interest, the interest accrued during a certain period is added to the balance, and then interest for the next period is calculated on the higher balance. Each period that an investment earns interest in this manner is called a compounding period. Compounding periods may occur at different intervals, such as quarterly or annually, depending on the terms of the investment account. You can calculate the number of compounding periods to determine the future value of the account. The more frequently an investment compounds its interest, the faster it grows.
1. Compute the beginning value of your investment, its annual interest rate, the number of times it compounds interest per year and the number of years you expect to hold the investment. For example, assume you will hold an investment with a $1,000 opening balance for three years; also, assume the investment has a 5 percent annual interest rate and compounds monthly, or 12 times per year.
2. Multiply the number of times per year the investment compounds its interest by the number of years you expect to hold the investment to calculate the total number of compounding periods. In the previous example, multiply 12 by 3 to get 36 compounding periods.
3. Divide the annual interest rate as a decimal by the number of times the investment compounds interest per year to determine the interest rate per compounding period. In the example, divide 0.05 by 12 to get a 0.0042 interest rate per compounding period.
4. Add a value of 1 to the interest rate per compounding period. Raise the result by an exponent equal to the total number of compounding periods. In this example, add 1 plus 0.0042 to get 1.0042. Raise 1.0042 by an exponent of 36 to get 1.163.
5. Multiply the result from Step 4 by the starting balance of your investment to calculate the investment’s expected value at the end of the holding period. Concluding the example, multiply 1.163 by $1,000 to get a future value of $1,163 at the end of three years.