What Is a Compounding Period?

Mary McMahon

A compounding period is a length of time during which interest accrues, and will be added at the end of the period. Interest may compound weekly, biweekly, monthly, quarterly, or in other intervals. Understanding when interest is added to a balance can be important, as this can affect performance on interest-bearing bank accounts or debt instruments like mortgages and revolving lines of credit. For convenience, interest is often quoted in an annual rate which adds the periods together, as this makes comparisons easier for consumers.

Man climbing a rope
Man climbing a rope

Annual or semiannual schedules are common for compounding periods, meaning that interest is added once or twice a year. For accounts like revolving lines of credit, the period may be a month. In all cases, the interest is added directly to the account at the end of the compounding period, rather than being charged or paid out to the consumer. A person with a loan, for instance, grows interest over time. As long as the monthly payments are large enough, they should pay off interest and eat into the principal, allowing the consumer to work towards paying the loan off.

Consumers may need to know when their interest is compounded for bookkeeping and accounting purposes. Statements from the financial institution should also provide information about when interest was applied to an account. If the institution wants to change policies, it typically needs to notify the customer, by law, to provide information about the change and how to protest or reverse it. Consumers should pay close attention to notices about compounding period and billing cycle changes to avoid unpleasant surprises.

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Institutional policy on compounding periods is discussed in documentation for financial products. Customers who want more information on the compounding period and other details can ask for this documentation or meet with an adviser to get specific advice. For savings, the benefit of compound interest is the ability to grow the account over time; if a savings account earns three percent every quarter, for example, $100 United States Dollars (USD) turns into $103 USD after three months, $106.90 USD after six months, and so forth. These incremental earnings start small, but pay out significantly over time.

Similar growth patterns can also be seen with debt, which commonly follows a compounding period model as well. If consumers fail to keep pace with the growth of interest, they can end up owing more than they originally borrowed. Continued compounding will help the balance grow and continue to grow unless the consumer makes a large bulk payment to pay off the interest and start to bring down the original balance.

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