Definition of Compounding
Compounding is the process of adding interest to the principal to make a new principal to charge interest on. It is different from simple interest like a coupon payment on a corporate bond. When a corporate bond pays interest it multiplies the interest rate with the principal value. In the case of compound interest, the interest is accumulated over each period into the principal. The fixed deposit accounts have a compounding mechanism.
Assume you have $10000 in cash that you don’t need for the next five years. The bank offers 10% interest compounded quarterly for five years. After five years you will get $16,386.16.
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