What happens in compounding in savings?

• A. Earnings are withdrawn for spending
• B. Earnings are reinvested to generate additional earnings over time
• C. Principal is taxed separately from earnings
• D. The account balance remains constant

Answer: (B)

In savings compounding, the earnings are added back to the principal so they start earning interest themselves. This reinvestment of earnings creates growth on top of growth over time, so the balance builds faster the longer you let it sit and the higher the interest rate and compounding frequency.

For example, $100 at 5% interest compounded annually becomes $105 after one year, then $110.25 after two years, and so on. Each year, the interest is earned on a larger amount, so you get “interest on interest.”

If you were to withdraw the earnings, the next period would start with a smaller base, and the growth from compounding would be reduced. The idea described here is different from simply taxing earnings or maintaining a constant balance, which do not capture the growth mechanism of compounding.

So the statement that earnings are reinvested to generate additional earnings over time best captures what compounding is about.