Which scenario best demonstrates the effect of compounding in savings?

• A. You withdraw earnings each year before reinvesting
• B. You earn simple interest only on the principal
• C. Fees reduce your balance but do not affect earnings
• D. Reinvesting earnings to generate additional earnings over time

Answer: (D)

Compounding grows your money by earning returns on both the original amount and the returns that have already been added. When you reinvest those earnings, they become part of the balance and start earning their own returns, so the growth builds on itself over time.

For example, starting with $100 at 5% interest: after one year you have $105. In year two, you earn 5% on $105, which is $5.25, bringing the balance to $110.25. The amount of earnings each year increases because you’re earning interest on previously earned interest. If you instead withdraw earnings each year, the balance that can earn interest stays about the same, so you don’t experience this accelerating growth.

Thus, reinvesting earnings to generate additional earnings over time best demonstrates compounding. The other scenarios either keep the principal from growing (no compounding), involve simple interest (returns don’t earn on past earnings), or reduce the balance without triggering the compounding effect.