Compounding refers to generating earnings from previous earnings.

Let’s take a simple example of 2-year, 5% deposit compounded annually. If we invest US$100 at the beginning of year 1, at the end of year 1 we will have US$105, a gain of US$ 5. At the end of year 2 we will have US$ 105*1.05=110.25, a gain of US$ 5.25, because the interest in year 2 will be calculated on the whole amount we had at the beginning of the year, i.e. US$ 105.

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