Compounding is when an investment increases exponentially in value over time. The growth is exponential because both the principal investment and the interest continue to earn interest. For example, if a person invests $20,000 in a company, and earns 25% interest on that investment in the first year, at the end of the year, his investment will be worth $25,000. The following year, it is the full $25,000 that earns the same interest, bringing its value to $31,250 the following year. That means, with compounding, the net amount earned from interest every year is higher than the previous year.
Compounding is a primary tool in money management. The longer you leave an investment in without cashing it out, the more money you are able to earn from your initial investment. The biggest advantage of exponential earning rather than linear earning, is that if the earning was linear, the net increase would remain the same every period. That is to say, if a person earns $2,000 in interest per year, then that is the increase – no matter how much money is in the investment at the time. Compounding, on the other hand, ensures that the more an investment is worth every year, the higher the net increase will be. As a result. Investors are encouraged to leave both the principal and the interest earned in the investment, and watch it grow more quickly than if they kept only the principal.