Financial Terms
Compounding

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Definition of Compounding

Compounding Image 1

Compounding

The process of accumulating the time value of money forward in time. For example, interest
earned in one period earns additional interest during each subsequent time period.


compounding

When an asset generates earnings that are then reinvested and generate their own earnings.



Related Terms:

Compounding frequency

The number of compounding periods in a year. For example, quarterly
compounding has a compounding frequency of 4.


Compounding period

The length of the time period (for example, a quarter in the case of quarterly
compounding) that elapses before interest compounds.


compounding period

the time between each interest computation


Continuous compounding

The process of accumulating the time value of money forward in time on a
continuous, or instantaneous, basis. Interest is earned continuously, and at each instant, the interest that
accrues immediately begins earning interest on itself.



Continuous Compounding

The process of continuously adding interest to a principal plus
interest amount and calculating the resulting compound amount


Discrete compounding

compounding the time value of money for discrete time intervals.


Compounding Image 2

Discrete Compounding

The process of adding interest to a principal plus interest amount
and calculating the resulting compound amount at specific
intervals, such as monthly or annually


Annual percentage yield (APY)

The effective, or true, annual rate of return. The APY is the rate actually
earned or paid in one year, taking into account the affect of compounding. The APY is calculated by taking
one plus the periodic rate and raising it to the number of periods in a year. For example, a 1% per month rate
has an APY of 12.68% (1.01^12).


Discounting

Calculating the present value of a future amount. The process is opposite to compounding.


Discounting

The process of finding the present value of a series of future cash flows. Discounting is the reverse of compounding.


Effective annual interest rate

An annual measure of the time value of money that fully reflects the effects of
compounding.


Effective rate

A measure of the time value of money that fully reflects the effects of compounding.


Nominal

In name only. Differences in compounding cause the nominal rate to differ from the effective
interest rate. Inflation causes the purchasing power of money to differ from one time to another.



 

 

 

 

 

 

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