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Small sums can grow into large sums through compounding. Photo: Damian Gadal, Flickr

This article was originally published on Sept. 4, 2015. It was updated on April 5, 2016.

Once you learn about the magic of compounding, it's natural to want to put its power to work building your wealth. You might then wonder what kind of investment accounts earn compound interest. Let's review compounding itself, along with interest, and then tackle the different kinds of accounts you might consider.

What is interest?
Compounding is often referred to in relation to interest. Interest is essentially a reward for lending money. Banks charge interest when they lend money for mortgages or car loans, and credit card companies charge it, too, when you carry a balance of debt on your card. You can collect interest if you have money in certain bank accounts or other accounts. That's because the money you have in your bank account is available for the bank to use, such as when it lends money to other customers. Thus, it rewards you for leaving your money with it.

Interest comes in two primary varieties: simple and compound. If you have $1,000 in an account that pays you 3% simple interest annually, you'll collect $30 each year. If the interest is compound, then you will get $30 in your first year, and if you have $1,030 in your account the next year, you'll collect 3% of that, or $30.90. That's compounding doing its thing. 

What is compounding?
Compounding is happening when your investment grows each year -- and when the amount it grows by also grows. In other words, your investment generates earnings, and then those earnings generate earnings of their own. It's a relatively simple concept, but with mind-blowing possibilities, as the longer you let your investment grow, the more rapidly it will grow. Check out this example of a single $1,000 investment growing at 10% annually:

 

It Becomes

Gain in Previous 5 Years

In 5 years

$1,611

$611

In 10 years

$2,594

$983

In 15 years

$4,177

$1,583

In 20 years

$6,728

$2,551

In 25 years

$10,385

$3,657

In 30 years

$17,449

$7,064

In 40 years

$45,259

$27,810

In 50 years

$117,391

$72,132

See? Over the first five years, your modest investment grows by $611. But decades later, it's growing by tens of thousands of dollars every five years. And that's just with a single $1,000 investment. Imagine what happens if you start with $5,000 or $10,000 and if you add more money to your account regularly.

So where can you take advantage of this kind of growth?  

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Many bank accounts offer compounded interest, though current rates are relatively low. Photo: Mike Mozart, Flickr.

Bank accounts earn compound interest
Bank accounts are classic compounding vehicles. A key feature of most savings accounts is the interest they pay, which will typically be higher than interest you can earn on checking accounts. (Many checking accounts pay no interest at all.

You can also earn compounded interest in money market accounts and certificates of deposit (CDs).

Some bonds earn compound interest
Many bonds pay fixed interest sums, but some, such as zero coupon bonds, incorporate compounded growth. A typical bond might have you paying the face value of the bond, which might be $10,000, and then collecting regular interest payments (often referred to as coupons) before getting the face value back at maturity. With a zero coupon bond, though, even though its face value might be $10,000, you'll pay less for it, such as, perhaps, $9,500. You'll receive no interest payments, but at maturity, you'll collect $10,000, not the $9,500, with the difference representing the compounded value of interest payments.

The power of compounding -- in non-interest-bearing investments
It's important to understand that the compounding is at work in scenarios other than interest, too. Think, for example, of stocks that pay dividends. If you reinvest your dividend payments into shares of more stock, then those shares will grow, too, ideally kicking out dividend payments of their own. The reinvestment can help your portfolio grow faster than it otherwise would, if you didn't reinvest those sums.

Compounding can also help you project your portfolio's performance, for financial planning purposes. If you have a portfolio of $100,000 in stocks, for example, and you hope that it will grow by at least an average of 7% annually over the coming 20 years, you can run the numbers and see that you can expect to have at least $387,000 in 20 years.

It's smart to aim for compounded growth in your portfolio. Bank accounts won't offer you rapid growth because of the current low interest rate environment, but don't always write them off. There have been plenty of years with interest rates in meaningful ranges and some years with double-digit interest rates, too. And remember that stocks can give you compounded growth, too.

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