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What Is Compound Interest?

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t, pays it” – Albert Einstein.

Such a strong quote from such a brilliant individual. Compound interest is an incredibly powerful tool that has built tremendous wealth for centuries. 

But, what exactly is compound interest and why should you care? Simply put, compound interest is the interest you earn on your initial principal balance plus all the previous interest payments you’ve received. 

How Does Compound Interest Work?

The easiest way to understand compound interest is to see an actual example. 

As shown above, the initial principal balance on this investment is $100,000. The investor is earning a 5% interest rate per year, however, instead of withdrawing that $5,000 interest payment each year, the investor rolls it into principal balance. Therefore, for each subsequent year, the account earns 5% interest on a larger balance, which generates more money. 

If the investor were to earn 5% per year for 5 years, and withdraw their interest payment each year, they would earn $25,000 over a 5-year period. However, using compounding interest, the investor earns $27,628 in interest over the same 5-year period. 

Growth of Compound Interest

Compound interest is so powerful because of its endless growth potential. Warren Buffett credits a lot of his success and wealth to the growth he’s seen through compound interest. By simply reinvesting all profits or dividends, you multiply your purchasing power for the years that follow. As a result, you multiply your earning potential. 

What Are Compounding Periods?

A compounding period is the duration of time between the last time interest was paid or compounded. Depending on the investment, the compound period can be daily, weekly, monthly, bi-annually, or yearly.

For example, if you have an investment that pays interest once per year on January 15th, every January 15th you’ll receive your interest payment. You can either roll that payment into the account balance to earn a greater return for the following year, or you can withdraw that interest and use it as income. 

Calculating Compound Interest

In today’s age, the easiest way to calculate compound interest is through a compound interest calculator or spreadsheet software. There are a few variables you’ll need to know to properly calculate what you’ll earn:

  1. P, or your principal amount. 
  2. R, or your interest rate 
  3. N, or the number of times interest is compounded
  4. NT, or time

Example of Compound Interest

There are various ways an investor can earn compound interest. Certificate of deposits, bonds, reinvesting dividends from stocks, and real estate investment trusts all provide the possibility of earning compounding interest. The sooner you start investing, the better. Time is the single greatest wealth generating tool in existence. 

Who Benefits From Compound Interest?

As an investor, compounding interest works in your favor as it allows you to multiply your account size over time. The larger your account size is, the more money you can earn each year in interest. Compounding interest will help grow your account quicker than regular interest installments. 

However, a bank also benefits from this financial phenomenon. The majority of credit cards have compounding interest associated with them, and the compound period is typically daily. This means the amount you owe grows everyday, and you pay interest on the increasing amount outstanding. When compound is used against you, it can certainly set you back financially. This is why credit card debt is such a crippling debt to escape from! 

What Is Continuously Compounding Interest?

Continuously compounding interest means your principal balance is constantly earning interest, and the interest is always reinvested. As a result, your interest earns interest, and your overall account balance continuously compounds. As mentioned above, this is great for an investor.

But, if you have debt that continuously compounded interest, such as a credit card, this is a very dangerous expense that can significantly hurt your financial picture. 

What Is the Time Value of Money?

Time value of money, also known as TVM, is a financial concept that suggests your money is worth more today than the identical sum at a later date in the future.

For example, $1,000 today has a greater purchasing power compared to $1,000 twenty years in the future. This is because of inflation. As time progresses, everything gets more expensive. Housing prices, gas, groceries, wages, etc, are all impacted by inflation. 

This equation becomes increasingly more important when you start talking about retirement, considering you’ll need to have enough money saved up to sustain your quality of life throughout your golden years. Compound interest helps do just that.

You can compound your money and investments at a greater rate than inflation, which will protect and enhance the purchasing power of your dollar over time. The sooner you get started investing in investments that compound interest, the better off you will be. 

What Are Compound Interest Investments?

One of the most common examples of compounding interest would be stocks that pay dividends. A dividend can be a great secondary stream of income in your retirement years, but if you start investing in quality stocks that pay a healthy dividend early on in your career, you’ll have the opportunity to reinvest those dividends each interval they are issued.

This is known as a Dividend Reinvestment Plan and is an incredibly powerful tool to have in your financial toolbox! There are also tax incentives and additional benefits if you take advantage of a dividend reinvestment plan. 

Benefits of Compounding Interest

There are an endless number of benefits compounding interest provides the investor. Let’s examine the most common:

Benefit #1

First and foremost, compound interest allows an investor to grow their principal balance without investing any additional capital. 

Benefit #2

Compounding interest helps you combat inflation, or the decline in your money’s purchasing power over time. 

Benefit #3

Additionally, compounding interest allows you to earn a greater rate of return without increasing risk in one’s portfolio or investment. 

Have This Force on Your Side

In the world of finance, you’ll always want to have the compound interest force on your side! You want to be the one earning compounding interest, and you’ll always want to avoid debt that incurs compounding interest on the outstanding loan balance. 

There are various investment options out there that can help you generate a healthy rate of return. Determining which investment mix is right for you and your goals is where it becomes more complicated. 

Working with a financial advisor will help you navigate the complexities of investing. Remember, the greatest wealth building tool that has ever existed is time. The sooner you get started, the more time you have, and the more wealth you’ll be able to generate! The right financial advisor will help you multiply your returns and you’ll watch your account value grow each year!