What Is Compounding and How Does Compound Interest Work in Crypto?

What Is Compounding?

Compounding is interest on interest: you leave earnings in your existing balance, so you also earn returns on earlier earnings later on. Put simply, not only does your original deposit grow, but so does what you’ve earned along the way.

Say you have 100 tokens and earn 5% on them. After the first period, you have 105 tokens. If you leave those 5 extra tokens there, the next return is calculated on 105 tokens instead of 100. With a positive return that stays the same, your balance grows faster and faster. That’s called exponential growth.

In crypto, “interest on interest” is a useful term, but sometimes a simplified one. The earnings can come from staking rewards, lending, or token incentives, for example. Whether those earnings are automatically put back to work depends on the protocol and product.

Key Takeaways

• Compounding means earnings stay in your balance.
• That means you can later earn returns on earnings you already made.
• With a positive return that stays the same, the number of tokens grows faster than with simple payout only.
• Crypto earnings can come from staking, lending, or token incentives.
• Automatic reinvestment is not set up the same way in every crypto product.

How Does Compounding Work?

Compounding works in a repeating cycle: you start with a balance, earn returns, add those returns, and then earn returns on the higher balance.

Example: You lock up 100 tokens with an annual return of 10%. After year one, you have 110 tokens. If those 10 extra tokens stay there, in year two you earn 10% on 110 tokens. That leaves you with 121 tokens. So you end up with more tokens than you would have without compounding.

That reinvestment can happen in two ways:

• Automatically: a protocol lets your position, token balance, or the value of your position grow on its own.
• Manually: you claim rewards yourself and then put them back into staking, lending, or a vault.

The more often earnings are added, the higher the final value in a calculation example with the same fixed annual rate. But in the crypto market, returns are often variable. A fixed rate of, say, 5% is mainly useful for understanding how the math works, not as a prediction of what you’ll actually earn.

Also important: automatic growth does not always mean a protocol uses the classic compound interest formula exactly. So always check how the specific product handles its earnings.

How Is Compounding Calculated?

With a fixed annual rate, you can calculate compounding with this formula:

A = P × (1 + r/n)^(n × t)

That may look complicated, but the parts are actually pretty simple:

• A is your final value.
• P is your original deposit.
• r is the annual rate as a decimal. So 10% is written as 0.10.
• n is how often earnings are added per year.
• t is the number of years.

Are earnings added once a year? Then the formula is simpler:

A = P × (1 + r)^t

Say you stake 1,000 tokens, with a fixed annual return of 10% and yearly compounding. After two years, the calculation is:

1,000 × (1 + 0.10)^2 = 1,210 tokens

That means you’ve built up 210 tokens in earnings. Your original deposit of 1,000 tokens is not included in that.

You’ll also often see APR and APY in crypto. APR is a nominal interest rate and does not automatically include the effect of compounding. APY does: it shows what the return over a year would be if earnings were added again during that year.

Think of this formula mainly as a scenario. In crypto, rates can change, reward schedules can shift, and network fees can add up. The price of a token can also drop. That’s why it’s smart to look not only at the number of tokens, but also at the value in euros.

What Is the Difference Between Compounding and Simple Interest?

With simple interest, you always earn returns only on your original deposit. With compounding, you also earn returns on the earnings that have already built up.

With 1,000 tokens and a fixed return of 10% per year, it looks like this after two years:

• Simple interest: 100 tokens in earnings each year. After two years, you have 1,200 tokens.
• Compounding: after the first year, you have 1,100 tokens. In year two, you earn 10% on 1,100 tokens, which brings you to 1,210 tokens.

After two years, the difference is only 10 tokens. But the longer you keep reinvesting earnings, the bigger the effect can become, as long as the return stays positive. A higher return and more frequent reinvestment also increase that difference.

This example is only about token amounts at a hypothetical fixed return. It says nothing about price changes, fees, or your final result in euros.

How Is Compounding Used in Crypto?

In crypto, compounding can look very different. Sometimes your balance grows automatically, sometimes your number of tokens stays the same but the value of your position rises, and sometimes you have to reinvest manually.

With proof-of-stake, validators can earn rewards for their role in the network. A validator checks new blocks and helps keep the network secure. On Ethereum, validators with Type 2-withdrawal credentials can have rewards counted toward their effective balance, up to a maximum of 2,048 ETH. That increases their validator weight and can lead to higher future rewards.

With liquid staking, you often see one of these two models:

• A rebasing token adjusts your balance regularly. With stETH, the number of tokens in your Wallet can therefore increase.
• A token can keep the same quantity while the exchange rate rises. With wstETH, your amount of wstETH stays the same, but over time it represents more stETH.

This also happens in DeFi lending. If you add crypto to a lending pool, you may receive a position token. On Aave, aToken balances grow automatically with the current supply rate. That rate depends, among other things, on how much of the lending pool is being used at that moment.

Compound V2 works differently with cTokens. Your number of cTokens basically stays the same, but the exchange rate against the underlying asset rises as interest builds up in the market.

Manual compounding takes a bit more work. You first claim your rewards and then reinvest them. Sometimes that means swapping tokens or depositing them into a vault. That can cost network fees, so with small rewards it’s especially important to check whether reinvesting is actually worth it.

How Does Compounding Work at Finst?

With staking at Finst, staking rewards are automatically staked again. So you don’t have to reinvest received rewards yourself to benefit from compounding.

Staking rewards are calculated daily based on the number of tokens you hold and the current APY. Every Monday, the accumulated rewards are paid out in crypto. Those tokens are then automatically included in staking.

For example, if you stake 100 tokens and over time receive 2 tokens in staking rewards, those 2 extra tokens can also be included when future staking rewards are calculated after payout. So you earn rewards not only on your original 100 tokens, but also on rewards you received earlier.

This is also called auto-compounding. The actual return is not fixed: the APY can change, and the price of the staked crypto can also go up or down.

At Finst, staking is flexible. There is no lock-up period, and staking rewards are paid out weekly.

Staking crypto-assets involves the risk of losing your capital. The staking service provided by Finst B.V. is currently not regulated under MiCAR. This means that the safeguards and protections applicable to regulated crypto services may not apply to this service. For more information, please refer to our Risk Disclosure.

What Are the Benefits of Compounding?

The biggest possible benefit of compounding is simple: earlier earnings can generate new earnings themselves. That can make your number of tokens grow faster with a positive return than if you keep cashing everything out.

Compounding can also be practical. If a position token, rebase, or rising exchange rate handles earnings automatically, you have to claim and reinvest rewards less often. That saves steps and can also save network fees.

For certain Ethereum Type 2 validators, there’s another technical benefit. Rewards can increase the effective balance, within the protocol limit of 2,048 ETH. A higher effective balance means higher validator weight and possibly higher future rewards.

Time plays a big role here. The longer earnings are left to grow again, the stronger the compound interest effect becomes in theory. That only applies if returns stay positive and fees or price drops don’t wipe out the result.

What Are the Risks and Limits of Compounding?

Compounding does not make crypto less risky. It can grow your number of tokens, but if the price of that token drops hard, the value in euros can still end up lower, even if you managed to get more coins. Crypto prices can swing a lot, and a token can even lose all of its value.

The risks differ depending on how you use compounding:

• Price risk: more tokens does not automatically mean more value in euros. If you receive rewards in a different token, you also take on extra price risk and possibly conversion costs.
• Protocol risk: with DeFi lending or liquid staking, you rely on the rules and technology of the protocol. A problem there can affect your position.
• Third-party risk: if you use a staking service or crypto company, you also depend on that party. Technical errors and bankruptcy can create risks.
• Liquidity risk: sometimes you can’t exit right away. In extreme conditions or when many withdrawals happen at once, the market liquidity for stETH, for example, can dry up and a withdrawal queue can get delayed.
• Cost risk: when you manually claim, swap, and reinvest, you often pay network fees. Small rewards can mostly disappear because of that.

Staking also comes with risks. Validators on Ethereum can earn rewards, but under certain conditions they can also be penalized. In case of harmful behavior, a validator can be slashed, which means part of the stake is lost.

DeFi lending rates are also usually variable. The return on Aave, for example, changes with the utilization rate of the lending pool and other protocol settings. So an attractive APY today is not a promise for tomorrow.

Finally, protection in crypto is limited and depends on the product. DeFi generally is not regulated, although the situation can differ by product. So don’t just look at a high APY. Also check where the earnings come from, what risks you’re taking, and what fees are involved.

Conclusion

Compounding means letting your earnings grow again. Instead of only earning returns on your first deposit, you also earn returns on tokens you already earned earlier. Over the long term, that can make a clear difference.

In crypto, that works through different forms, like staking, liquid staking, and DeFi lending. Sometimes it happens automatically, sometimes you have to claim rewards and reinvest them yourself. The classic formula helps explain the idea, but it is not a reliable prediction for crypto returns.

So the main thing is to look beyond the return shown on screen. Check whether earnings are really being reinvested, whether the rate is variable, what fees you pay, and what price, protocol, and liquidity risks you’re taking.