Discrete Compounding

Financiers aren't that different from chefs. They have to decide how much of what to put where, find the best method of mixing it all together, and keep customers coming back. They are artisans of their crafts.

In finance, “discrete compounding” is a recipe that has multiple variations. Discrete compounding is a method of calculating compound interest at certain points in time. Compounding interest, as opposed to simple interest, is where the interested is calculated, then added to the principal before the next round of interest is calculated. Because the new interest at each calculation round is added to the principal, a loan with compounding interest will rise much faster than a loan with simple interest (think: exponentially rather than linearly).

The “discrete” in “discrete compounding” just means this snowball process happens at certain intervals of time, say weekly, monthly, or possibly annually. This is different from continuous compounding, which, as the creative name would have you assume, is compounding continuously (usually daily, but it could be more often), and not at set intervals of time.

Let’s think about your bank account and how it calculates interest that it gives you. You might think having an account that has more instances of compounding would mean much more money for you, but it doesn’t. The more often the money sitting in your bank is compounded, yes, the more money you will get technically, but by a lot less than you’d think (like...a lot less).

For instance, one round of compounding (i.e. an account with annual discrete compounding) on $1,000 at 2% would get you $1,020. If your account was continuously compounding (daily) for a year on that same $1,000, then you’d have $1,020.20. Yep, compounding that $1,000 365 times in a year only gets you 20 cents more than compounding once in a year. Still, because compounding interest grows at an increasing rate, that can add up over time, bit by bit. By bit by bit.

By bit.