Compounding is basically how your money will grow by a bigger and bigger amount each year as long you are getting positive returns. Why is this? Well, as long as your funds are growing there will be more of them to move into the next year, and that means there are more dollars for interest to do its work on.
Let's take a look at this in action, we're going to start off with an easy example that uses only a one time deposit.
The formula we're going to work with for this first example looks like this:
A = future value
P = principal (initial investment)
r = rate of return
n = number of compounding periods
t = term (number of years invested)
Now let's use some numbers...let's say you make a deposit of $10,000 and want to know how much it will be worth in 30 years (without not further deposits). We're going to assume a 5% rate of return and monthly compounding (so 12 periods in a year.
Once you get that all input you will get a result of A = $44,677.44. Over four times your original investment...not too bad hey?
Most people don't save for retirement this way, though, it's much more common to make small deposits more frequently...so now we're going to complicate things and look at making monthly deposits. Here's the formula we'll be using for multiple deposits:
And now time to input those numbers; this time we're going to make $200 monthly deposits ($2400/year) for 30 years with a rate of return of 5% and monthly compounding. Without compounding this would be a total investment of $72,000 ($200/month for 30 years).
This formula looks a little crazy, but once you get it all figured out the total future value will be $166,451.73. It's not as significant an increase as in the first example because you start out with a smaller amount but your money still more than doubles in that period so....worth it!