The Power of Compound Interest

Earning interest remains one of the cornerstones of investing and lets you earn passive income by putting your money into interest-bearing securities or accounts. Compound interest allows you to increase the value of funds held in interest-bearing accounts or securities. In this article, Benzinga examines the benefits of compound interest and how it can boost your net worth. 

What is Compound Interest?

Compound interest can best be described as “interest on interest.” In other words, the interest you receive on an investment like a certificate of deposit is added to the original principal and subsequently accumulates or “accrues” additional interest that helps grow your investment even further.

Compound interest arises from reinvesting interest earned for a particular period instead of paying it out. Thus, interest paid in the following period is on the initial deposit plus any interest that has accrued in the account.

For example, if you open an interest-bearing savings or checking account, the interest you receive on the account’s balance goes into the account and is added to the existing balance. Thereafter, you receive interest on both the accrued interest and on the initial deposit, generating compound interest. As you look at compounding interest, remember that compounding frequency can make a difference as some interest payments are compounded more often than others.

Compound interest can enhance the value of your portfolio over time, especially if you hold predominantly interest-bearing investments like certificates of deposit or bonds. By increasing the value of your portfolio through receiving both interest and compound interest, the amount of your net worth held in such instruments should rise over time. 

Not sure of the returns you’ll see in your bank account? Determine the APY you’ll get and try a compound interest calculator. Don’t forget to subtract any maintenance fees you might be charged.

Where Do you Encounter Compound Interest?

You often see interest compounded in the different types of savings accounts you can open at most financial institutions. You might also see compound interest paid on fixed income securities like bonds. This isn’t a savings rate, but it’s a percentage yield on a fixed price investment.  

Note that interest can be compounded on any frequency schedule, irrespective of the asset or the account type. Common compounding frequency examples include daily, monthly and annual compounding. You might even find continuous compounding. 

Also, the number of compounding periods can significantly affect the amount of interest you earn over time. Be sure to check how often interest is compounded when you intend to make a long-term investment that earns compound interest.  Compound interest can be obtained from a number of different types of investments. Several common investments where you can enjoy compound interest or a similar benefit are listed below. 

High Yield Savings Accounts 

One of the safest and most readily available ways to earn compound interest is via a high yield savings account. This type of investment can suit people with a steady income who make frequent deposits to the account. To maximize your returns, choose a savings account that compounds interest daily instead of weekly or monthly since your account balance will increase at a faster rate. Also, having your money in a savings account at a bank usually gives you immediate access to your funds in case of an emergency. 

Money Market Checking Accounts

A money market checking account generally pays compound interest. It also lets you write checks and withdraw money using an ATM card, although you may have a limit on how many transactions you can make each month, and you might be charged a fee if your balance falls below a certain amount. Since money market accounts usually pay a very low rate of interest, diversifying your investments into higher yielding assets probably makes the most sense if you plan on increasing your net worth through compound interest.

Bonds

Bonds are securitized corporate debt units that companies issue and that pay a fixed rate of interest. Your interest returns from bonds can vary widely depending on the type of bond you choose to invest in and its inherent risk. For example, government-issued bonds offer the lowest risk and interest rates but the highest liquidity, while municipal bonds can carry more risk and less liquidity. The bonds with the highest returns are generally short-term corporate bonds that mature in under a year and zero coupon bonds that sell at a discount and must be held until maturity to get the full interest benefit. You can get a compounded effect by reinvesting bond coupon payments into more bonds. 

Dividend Stocks

A stock is an investment that represents a share of ownership in a company. Many stocks provide regular dividends that consist of money the company pays to its shareholders from its profits or reserve funds. If you reinvest those dividends into the stock, then that has a compounding effect. Dividend stocks typically present a higher risk versus other compound investments, since stocks can rise or fall in value. If you call the market right and select a dividend stock with good fundamentals, then you might benefit from capital appreciation as well as the compounded dividends. You can also choose preferred stock that may not be as liquid as regular common stock, but it could provide higher dividends and greater safety in case of the company’s liquidation. 

Compounding Makes Your Money Grow Faster

When you deposit funds into an account or investment with compound interest, your money grows faster because you get interest on your new balance that includes interest previously paid. A formula that tells you how much your principal balance (and investment return) will rise to (P') based on the initial principal amount P appears below:

P'=P(1+r/n)^nt

Where:

P' = the new amount of principal

P = the original deposit amount or principal

r = the annualized nominal interest rate expressed as a decimal

n = how frequently interest is compounded per year

t = the number of time periods elapsed in years

The total amount of compound interest (I) generated by this investment is then equal to the new amount of principal (P') minus the initial deposit amount (P):

I = P'-P= P(1+r/n)^nt - P = P((1+r/n)^nt - 1)

As an example of how compound interest can make your money grow faster, consider a situation where you deposit $50,000 in a savings account with monthly compounding at an interest rate of 2% per year for 5 years.

In this case, P=50,000, n=12 periods per year, and t=5 years. You also need to convert the interest rate r into decimal terms by dividing 2% by 100 to get r=0.02.

You can now solve the compound interest equation for P' like this:

P' = $50,000*(1 + 0.02/12)^(12*5)

P' = $50,000*(1 + 0.001666667)^(60)

P' = $55,253.94

The total amount accrued as principal and interest on a $50,000 principal at an annual rate of 2% per year compounded 12 times each year over 5 years is $55,253.94. Note that the compounding of interest gives you an additional $253.94 over the $55,000 you would have received without compounding.  

As you can see from the above example, receiving compound interest boosts your money over time compared to what you would have gotten on an investment that only pays simple interest. Also, if you get paid interest that is compounded more often, then you get paid even more interest to help your deposit accounts grow faster.

Choose Compounded Over Simple Interest

Compound interest can be very powerful when you invest or save your money over long periods of time. Now that you know how much better getting compound interest is versus simple interest, you will probably want to seek out compound interest to get paid interest on your interest so that you can grow your savings as much as possible. As always, come back to Benzinga for more useful financial information or try a savings calculator.

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