Compounding effect
The additional growth or additional interest, resulting from the compounding effects of - for example - interest on interest.
Another example is the compounding effect of growth on growth.
Example
Interest quoted at 6% per annum, compounded annually, for two years maturity, means that the interest accumulated after two years is:
= ( 1.06 x 1.06 ) - 1
= 12.36% for the two year period.
Without the additional interest on interest, the total interest would have been simply
6% per annum x 2 years
= 12.00%.
So the compounding effect of interest on interest here
= 12.36% - 12.00%
= 0.36% over the two year period ( = 6% x 6% ).
When both the number of periods and the rate of growth/interest are low, compounding effects are relatively small.
When either the number of periods or the rate of growth/interest - or both - are greater, compounding effects quickly become very much larger.
