Compound interest is a powerful tool for people looking to build their savings or improve their investments. Knowing what it is, how it works and what investments can generate better returns over the long run could help you benefit the most from it and make smarter decisions about where to put your money. Here is everything you need to know about compound interest.
Compound interest, that Albert Einstein referred to as the "eighth wonder of the world", is a financial concept that has the power to transform small investments or savings into large fortunes over time. According to many, it is a life-changing method that has the capacity to accelerate the growth of savings and investments over time.
Commonly described as the “interest on interest", it is one of the most accessible tools for new investors, requires absolutely no skill, and can have a significant effect on how quickly your money may grow through the aka "snowball effect". Compounding, however, can also work against you, as in the case of high-interest credit card debt that accumulates over time. For this reason, it is also a great way to encourage yourself to pay off debt quickly and to start saving and investing money as early as possible.
Compound Interest - Key Takeaways
What is Compound Interest & How does it work?
To understand what compound interest is, first we shall briefly define interest as a general financial term. So, interest is the amount of money you receive when you access savings products or the amount you pay when you borrow money.
Now let's go very specific: "Interest" is money paid for money lent or deposited; "compound" refers to something composed of two or more elements. Considering this, compound interest is a method of estimating an investment's possible return that accounts for interest accrual over time. Basically, it refers to the process of creating "interest upon interest." In the simplest way, compound interest is when you earn interest on the money you’ve saved and on the interest that you have earned along the way.
Interests can be combined using compound interest on a daily, monthly, or even yearly basis. You will therefore receive interest on both the initial amount (the principal) and the interest that has accrued over time.
Let's assume you make a 1,000 EUR investment with 5% interest. You receive a 50 EUR interest payment after the first year, but you reinvest the interest you earned at the same 5% rate rather than getting it in cash. Your interest would be computed on a 1,050 EUR investment for the second year, or 52.50 EUR. Your third-year interest would be computed on a balance of 1,102.50 EUR, if you reinvest that.
Hence, compound interest means your principal gets larger over time and will generate larger and larger interest payments.
Simple vs Compound Interest
When it comes to borrowing, saving, and investing money, simple interest and compound interest are both important financial concepts. However, it is worth mentioning that simple interest is more often used in the context of loans or bonds, when interest is the same and there is no compounding, while compound interest is applied mostly for investment and savings.
What distinguishes compound interest from simple interest is the way the interest accrues. Compound interest accrues to both the principal balance and the accumulated interest, whereas simple interest simply accumulates on the principal balance. Unlike simple interest, compound interest lets your returns earn returns of their own.
To put it simply, simple interest is computed annually as a percentage of the principal amount. You can calculate it by multiplying the principal amount with the annual interest rate and the number of years you invest or borrow money.
For instance, you would pay 3,500 EUR in simple interest over the course of five years if you were to borrow 10,000 EUR and pay a simple interest rate of 7%. Upon investing 10,000 EUR in a bond with a 5% coupon, you will earn 500 EUR every year until the bond expires.
Simple interest formula
Here is how the simple interest formula works for a loan:
Simple interest = P x R x N, where:
P is the principal
R is the annual interest rate
N is the loan term (in years)
Here is an example of a simple interest formula for a home loan:
100,000 EUR (principal) x 0.06 (6% annual interest rate) x 15 (years of the loan term) = 90,000 EUR (simple interest)
How to Calculate Compound Interest
Knowing how to calculate compound interest is essential to monitoring your finances. The power of compound interest lies in its ability to grow quickly. Knowing how to calculate compound interest allows you to estimate how much your savings, investments or debts will grow over time. To better understand how compound interest works, let’s take a look at the following example.
Assuming you have 1,000 EUR in a savings account with a 5% interest rate and a 12-month compounding period. After one year, the original investment will earn 50 EUR in interest (1,000 x 0.05 = 50 EUR). The interest accrued is added to the principal balance for a total of 1,050 EUR. After another 12 months, the account earns 52.50 EUR in interest (1,050 x 0.05 = 52.50). The interest accrued is added to the principal and so on until you finally deduct money from the account.
Compound interest is calculated by multiplying the initial amount, or principal, by one plus the annual interest rate raised to the number of compound periods minus one. This will leave you with the total sum, including compound interest. You can then subtract the initial principal and you’ll be left with the total compound interest
Compound Interest Formula
Use the following formula to calculate compound interest:
Compound Interest = P [(1 + i)n – P], where:
P - stands for principal
i - stands for interest
n - is number of compounding periods
Let’s try to solve this equation with an example:
If we have a principal amount of 10,000 EUR, with an annual interest rate of 5% over a five-year period, the compound interest equation will stand as:
Compound Interest = 10,000 [(1 + 0.05)5 – 10,000
This results in a compound interest of 2,762.82 EUR over the next five years.
Top 5 Compound Interest Investments
While for savers, compound interest is mostly a matter of "money makes money", for investors, it can be a true mathematical wonder. This is one of the reasons behind the faith that investing works better in the long term than just saving.
By delivering returns on both your assets and the gains you make over time, compound interest can accelerate your efforts to build your wealth. Reinvesting your earnings is the best strategy to increase the compound interest you receive on your investment portfolio.
There are several investment options that may offer opportunities for compounding interest. From high-yield savings accounts to dividend stocks or REITs, the range is wide. However, understanding the risks and returns associated with each investment vehicle, as well as the importance of diversification, is crucial.
1. High-yield savings accounts
Learning how to get compound interest doesn’t have to be complicated. In fact, one of the most common compound interest investments are high yield savings accounts.
High-yield savings accounts are popular for compound interest when rates are attractive, and it’s easy to understand why. Banks lend out the cash you put into a savings account and pay you interest in exchange for not withdrawing the funds.
With increasing interest rates and inflation, money sitting in a non-interest-bearing account is money lost. These accounts often have no monthly fees and low minimum balance requirements. They also pay interest on deposits until you withdraw the funds.
Although a high yield saving account can often be more profitable than leaving the money in a standard saving account, it may struggle to keep up with rising inflation. An investor may want to explore other choices to keep ahead of rising prices.
2. Exchange-Traded Funds (ETFs)
If you’re wondering how to get compound interest with lower cost and diversified investments, then it might be a good idea to check out ETFs.
Exchange-traded funds have become incredibly popular and have amassed trillions of dollars in assets. During the previous 30 years, they have increased by 10.7% yearly on average, with the last five years seeing an astounding 245% rate of return.
When you buy shares in a dividend ETF, you can reinvest the dividends you earn back into the fund, compounding your returns. Some brokers offer DRIP for ETFs, making the process easy. Some examples include the Vanguard Dividend Appreciation ETF, the ProShares S&P 500 Aristocrats and the JPMorgan Equity Premium Income ETF.
Besides the fact that ETFs tend to charge low fees, you can easily buy and sell them at will as they are traded on stock exchanges like the New York Stock Exchange. However, remember that the ETFs you choose for your portfolio should entirely depend on your goals and risk tolerance.
3. Bonds and Bond Funds
Most individuals consider bonds to be an excellent compounding investment. In essence, these assets are loans that a borrower made to a creditor—a business or the government. The entity consents to provide the investor who purchased the debt with a certain yield.
Since bonds are among the few investment products that come with guaranteed returns, many people use them as a hedge against market fluctuations. Over time, reinvesting returns in revolving bond purchases can lead to sizable compound interest growth. Bond funds can achieve compound interest, too, and can be set to automatically reinvest the interest.
There are several risk thresholds for bonds. While U.S. Treasury securities are among the safest investments you can make, since they are backed by the full faith and credit of the US government, long-term corporate bonds are riskier but offer greater yields.
Although bonds could be riskier than certificates of deposit (CDs) or high-yield savings accounts, they can be attractive for investors looking for long term investments. This is because bonds' prices might change over time. The price of current fixed-rate bonds may decline when market interest rates rise. Conversely, the bond's price will increase if rates decline. The bond will pay back its face value to investors once it matures, regardless of what transpires in the interim.
4. Dividend Stocks
While stocks are often considered a good investment to compound growth, dividend stocks may be even better as they are a one-two punch, as the underlying asset can keep increasing in value while paying out dividends.
If you reinvest the dividends, dividend-paying stocks compound similarly to compound interest. Think of it as earning “dividends on dividends”. You can ask your broker to automatically purchase additional shares and reinvest all dividend payments you receive. However, there is a risk that the share price will drop more than the dividends paid out. Usually, it is considered that over time, a quality dividend stock will increase in value and pay out a larger dividend.
If you’re seeking for dividend income, you may want to look at “Dividend Aristocrats.” This group of S&P 500 companies has increased dividends per share for at least 25 consecutive years. Some of these companies include notorious names, such as Coca-Cola, Walmart and IBM. So, for a first-time investor looking to potentially outpace inflation while compounding income long-term, dividend stocks could be an option to go with.
But keep in mind that, given their tendency to be less dynamic and steadier in terms of price swings, these companies may not offer quite as many opportunities for big profits as some of the best growth stocks.
5. Real Estate Investment Trusts (REITs)
Investing with compound interest doesn’t just stop with stocks and bonds.
Real Estate Investments Trusts are considered an excellent approach to diversify your portfolio without having to own the property outright.
Each year, REITs deliver dividends to their shareholders equal to at least 90% of their taxable income. Just as with dividend stocks, investors can't take advantage of compounding over time unless they reinvest their dividends payouts.
REIT investors should keep in mind, however, that these vehicles differ significantly from savings accounts or certificates of deposit. Changes in interest rates can have a disproportionate impact on the real estate market relative to other assets since REITs are susceptible to interest rates fluctuations.
Additionally, the price of a REIT can fluctuate significantly over time, in contrast to a safe bank product or a fixed income asset.
How to maximize your compound interest
There are several actions you might take to boost your compound interest earnings, such as:
Start early
You might've heard the saying: "It's not timing the market. It's time in the market". With compound interest, the power of time is everything. One of the easiest ways to take advantage of compound interest over time is to start saving and investing early. Your money can benefit from compound interest for a longer period if it gets the chance to grow.
Don't withdraw money
No matter how attempting it may be, try to avoid withdrawing money from your savings or investment accounts. When you take out money, you are interrupting the compounding process. Your wealth might increase greater the longer you leave your money in a compound interest investment plan.
Contribute regularly
With regular investment contributions, compound interest has more room to build and allows your money to grow even faster. You can increase your earnings by setting aside or investing a specific amount of money each month. This helps you build a regular investment routine, even if you can only afford a tiny amount. You can boost your contribution if your financial status improves.
Final words
Compounding and time are powerful in a scientific manner that Einstein recognized and almost magical for regular investors. Using time to your advantage could be the best method to fully benefit from compound interest. The ideal portfolio for you is the one that consists of investments that you can stick with over the long run. Be consistent and leverage the power of compound interest to your advantage.
Your savings and retirement potential can be greatly enhanced by compound interest and compounding. You can achieve your goals with less of your own money when doing it effectively. However, it can also work against you, as in the case of high-interest credit card debt that accumulates over time. Compound interest is a great way to encourage yourself to pay off debt quickly and to start saving and investing money as soon as possible.
Whether your goals are to maximize your investment returns, or save for retirement or education, or both, knowing the power of compound interest can help you reach your long-term financial objectives.
Free resources
Before you start investing in stocks and other assets, you should consider using the educational resources we offer like CAPEX Academy or a demo trading account. CAPEX Academy has lots of free trading and investing courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader or make more informed investment decisions.
Our demo account is a suitable place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how CFDs work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged trading.
Sources:
https://www.investopedia.com/
https://www.forbes.com/
https://www.bankrate.com/