Simply put, the number of compounding periods in a year is referred to as Compounding frequency. For example, in a Quarterly compounding we have a frequency of 4 (12/3), half yearly compounding we have a compounding of 2 (12/6) and monthly compounding we have frequency of 12.

The more is the compounding frequency in a given time period, for the same principal amount, higher will be the return.

Number crunching to understand Compounding Frequency

It may be observed that under each, even with the same amount of principal put in i.e. Rs.10,000 earns different amounts of interest; the higher is the compounding frequency, the higher is the return generated. Kindly note that there is no withdrawal of funds in all the scenarios and the interest earned in each case is re-invested.

Formula used:

P- Principal amount,
r- Rate of interest,
n- compounding frequency;
for annual compounding r = r
for half yearly compounding r= r/2
for quarterly compounding r= r/4
for monthly compounding r= r/12

Once Einstein allegedly had said- “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”.

In the context of Investing, especially for an important goal like retirement, a small delay at the start could create a big shortfall later or increase the time period to achieving the goal significantly. Re-investment of returns and compounding are some of the most important fundamental concepts based on which the whole issue of saving for retirement planning, goal based saving & investing and creation of a retirement corpus works.

(Also read- Why understanding Time Value of Money and Purchasing Power important in planning your Retirement?)