When you invest your money in the market, you do so with the intention of earning interest. The interest is an addition to your principal capital and adds to your financial net worth. There are different types of interests you can make in the market. One of these is compound interest.
Compound interest is the interest earned on interest. It is one of the easiest ways to make money. In fact, some people also call it free money. While there is no magic trick in investing, compounding does offer great advantages. This is why it is famous by many names, including the eighth wonder of the world.
Compound interest is one of the most significant advantages of investing. It can offer financial growth and help you reach your target at a faster pace. However, knowing how compounding works and the right time to invest to make the most of it is essential. This can, in turn, help you pick the best accounts and investments that earn compound interest and maximize your returns. Consult with a professional financial advisor who can help you pick suitable investments and attain your financial goals. Keep reading to learn more.
What is compound interest in investing?
Compound interest is the interest earned on your savings or investments. It is calculated on the initial principal amount and the accumulated interest made previously. For example, if you invest $1,000 and earn an interest of $100 or 10%, your total balance will be $1,100. You will now earn interest on $1,100. If you make an interest of 10% again, your total wealth will be $1210.
Compound interest can be earned daily, weekly, monthly, and even annually. The more frequently your interest is compounded, the faster your money will grow.
How do compound interest investments work?
Compound interest can be earned on different types of accounts, such as savings accounts at the bank, mutual funds, stocks, etc. When you invest or save your money in these accounts or others of a similar nature, you earn interest. This interest helps you grow your money’s worth and create wealth. However, the interest you make does not sit idle. Instead, it is further invested in the market. This helps you accumulate a bigger pool of money in a shorter span of time. A compound interest investment increases your balance. As a result, you earn interest on continually growing balances.
Compound interest is also used for loans. But, in this case, a higher interest indicates a higher loan liability.
Compound interest is calculated by the following formula:
A = P (1 + [r / n]) ^ nt
Here,
- A is the amount of money accumulated after N years with interest
- P is the principal capital
- R is the rate of interest
- N is the number of times the interest is compounded in a year
- T is the number of years the amount is deposited or invested for
Factors affecting compound interest investments
Compound interest can be impacted by a number of factors, such as:
1. Rate of interest:
This is the rate of interest rate garnered by the savings or investments account. The higher the interest, the higher your return is at the end of the term, and vice versa.
2. Principal amount:
The initial deposit or investment is known as the principal amount. A higher principal amount can be a solid foundation for earning interest.
3. Frequency of compounding:
As stated above, interest can be compounded daily, weekly, monthly, or even yearly. The frequency can play a significant role in compounding as it determines the pace at which your investment grows. Daily or monthly interest credits can be more beneficial than yearly credits as it helps your money grow more quickly. Therefore, make sure to pay attention to this aspect when picking out a compound interest investment.
4. Duration:
The duration of investment is the amount of time your money stays invested in the market. It is also known as the time spent in the market. Investing for a longer duration can help you earn a bigger reward in the end, as your money has more time to grow.
5. Money transactions:
The number and value of deposits and withdrawals can impact the compound interest you earn. For instance, if you keep making deposits into an account, the value of your investments will increase. The interest will be applied to a higher amount, and it will grow faster. However, if you keep withdrawing money, the value of your balance will decrease. As a result, your investments will increase at a slower pace, and your overall returns will be hampered.
Compound interest accounts:
Here are some examples of accounts that offer compound interest:
1. Savings and checking accounts:
The savings or checking account at the bank is the most common example of compound interest. The money you deposit into the account earns interest and helps you grow your wealth.
2. Certificates of deposit (CDs):
CDs are also offered by banks. They provide interest that helps your money grow and have a fixed maturity. Any withdrawals made before the maturity period garner a penalty. However, if you let your money be, you can earn compound interest and increase your balance over time.
3. Bonds and bond funds:
A bond is a type of loan where you are the lender, and a company, municipality, or the government is the borrower. Bonds can be raised by different organizations when they need funds for their projects. In return, these organizations pay you interest. When you reinvest this interest back into the bond, you earn the benefits of compound interest. Bonds can be the ideal choice for someone looking for low-risk investment options, as bonds are less volatile than stocks.
4. 401(k) retirement account:
The company-sponsored retirement plan, 401k, also offers compound growth. 401ks provide a variety of compound interest investment options starting from stocks and bonds to mutual funds, CDs, money market accounts, and more. You can reinvest your dividends and grow your balance over time. Moreover, since a 401k has limited withdrawal provisions and you must stay invested in the plan till the age of 59.5 years to avoid a penalty, you end up saving more money over time with regular compound interest.
How to use the magic of compound interest in investing
Compound interest can boost your savings to a great degree. However, it is essential to pay attention to the factors listed below:
1. Look for the best compound interest accounts:
Accounts that offer high-interest rates can help you earn more money. When picking out an account, make sure to pay attention to the interest and the frequency of payment. Look for accounts that compound interest frequently, such as weekly or monthly and deliver a high interest to make more money in the long run.
2. Make sure you have time to grow your savings:
Compound interest can deliver its magic when you give it the required time. The power of compounding is best seen when you have a long-term investment horizon. The sooner you start saving or investing, or the longer you invest, the more money you can earn. For example, if you invest $1000 for ten years at a rate of interest of 10%, you can earn $2,994. If you invest the same amount for 20 years, you can earn $6,728; for 30 years, you can get $17,449. Timing is everything with compound interest. So make sure to select a suitable investment term for your investments if you really want to see a difference.
3. Be consistent with your investments:
Consistency is as vital in compounding as time. If you are regular with your investments and you make consistent investments, you can earn better rewards over time. It is essential to keep increasing your investments as you age or move up the ladder in your career. This, in turn, can help your money grow faster as it will increase your balance or principal amount.
4. Do not withdraw your money unless necessary:
Withdrawing your money can trigger your tax liabilities, impose unnecessary penalties, and lower the scope of earning interest. Leaving your cash untouched gives it a chance to grow in the market. Therefore, it is essential to let your money be so that it can grow with time. If you keep withdrawing your money, the account balance lowers, and the interest added makes a lower impact on your overall earnings.
When should you be wary of compound interest?
Compounding interest can work against you in situations where you borrow money, as listed below:
1. Loans and mortgage:
Compound interest does the opposite when you borrow money. Instead of increasing your returns, it increases your liabilities. It increases your loan burden and eventually adds to your debt liabilities. The accrued interest can interfere with a number of other goals, too.
2. Credit cards:
If you do not clear your credit card dues on time, the outstanding balance gets added to your next month’s credit balance. The following month’s interest is then calculated on the previous month’s due and the current month’s balance. This increases your credit card payments. It also impacts your savings, and your overall financial goals get affected.
To summarize
Compounding investments can enhance your returns by offering you increased returns. However, it is crucial to invest in suitable investments and invest for the long term to take advantage. It is also essential to understand that compound interest in the form of loans and credit cards can be harmful. So, make sure you’re aware of both the pros and cons of compound interest.
For further questions on how to manage your retirement accounts and save effectively for your future financial needs, visit Dash Investments or email me directly at dash@dashinvestments.com.
Sincerely,
Jonathan Dash
Founder and President
Email: info@dashinvestments.com