Compounding period definition
/What is a Compounding Period?
A compounding period is the span of time between when interest was last compounded and when it will be compounded again. When interest compounding occurs, interest is added to the principal on a loan. A shorter compounding period results in a larger amount of interest being payable to the lender.
For example, annual compounding means that a full year will pass before interest is compounded again. A lender may engage in more aggressive monthly or quarterly compounding, which increases the amount to be repaid by the borrower.
Example of a Compounding Period
Suppose you deposit $10,000 in a savings account at a bank that pays interest at an annual nominal rate of 8%, compounded quarterly. The annual nominal interest rate is 8%, and the compounding frequency is quarterly. Therefore, the interest per compounding quarter is 2%.
After the first quarter (January 1–March 31), the interest earned is $200 (calculated as $10,000 x 2%). The new balance after interest is compounded is $10,000 + $200 = $10,200.
For the second quarter (April 1–June 30), interest will now be computed on the new principal of $10,200. The calculation is:
Interest earned = $10,200 × 2% = $204
The balance after the second quarter will therefore be $10,404 (calculated as $10,200 + $204).
And this process repeats each quarter.