What effect does compounding have on investment growth?

Compounding significantly enhances investment growth by allowing the earnings generated from an investment to create additional earnings over time. When interest is calculated on both the initial principal and on the accumulated interest from previous periods, it leads to exponential growth rather than linear growth. This process means that as time progresses, the amount of interest earned increases because each interest payment is based on a progressively larger amount.

For example, if you earn interest on your initial investment and then continue to earn interest not just on your principal but also on the previously earned interest, the total amount invested grows much faster than if you simply earned interest on the initial amount alone. This concept is fundamental to understanding how investments can significantly increase in value over time, underscoring the importance of starting to invest early to maximize the benefits of compounding.