Compound interest: How to make it work for you
At a glance:
Simple and compound interest
How to make compounding work for you
The basic compound interest formula
Compounded interest and taxes
Summary of compound interest
One of the most well-known "secrets" to increasing your wealth is the phenomenon of compound interest. Compounding puts the earning power of money to work for you.
As a savvy investor, you should be thoroughly familiar with the concept of compounding and know some easy ways to put it to use.
Simple and compound interest
Perhaps you have heard of the miracle of compounding.
Innumerable investors have used it to their advantage to make their money grow faster than would be the case with simple interest. The great thing about compounding is that it doesn't require additional work on your part: You just sit back and watch your money grow.
How's that for an investment strategy?
Simple interest
There are two basic types of interest: simple and compound. Simple interest is the amount of interest earned on the original amount of money invested. Simple interest is paid out as it is earned and does not become part of an account's interest-bearing balance.
The invested amount is called principal. Let's say you invest $100 (the principal) at a yearly interest rate of 5%. Multiplying the principal by the interest rate gives you an interest payment of $5. This is your simple interest. The next year and each year thereafter, you will be paid $5 of interest on the principal of $100.
Compound interest
Compound interest (or dividends in the case of credit unions) is interest paid on interest as well as principal. At 5% interest compounded annually, you will have $105 after the first year. If you keep this investment for another year, you will be paid interest on your original $100 and on the $5 you made in interest the first year.
The longer you invest your money, the higher your interest payments will be, as the interest you accrue each year will be based on not only your initial investment but also the previous interest that has accumulated. This is what makes compounding interest so powerful.
With compounding, time is money
The longer an investment is allowed to compound interest, the more your balance should increase each year. In the case of compounding interest, time really is money.
Let's say you invest $1,000 for five years, with an annual interest rate of 5%. The difference in your investment earnings from simple and compounded interest will look like this:
How to make compounding work for you
The concept of compound interest can be applied through various methods.
Taking advantage of compound interest need not be a passive strategy on your part. The bigger your investment base, the more that time and math will conspire to build up your wealth.
That is why investment advisors suggest taking advantage of time and a schedule of periodic investing. The results build on themselves.
You can consider applying some of these active strategies by following a few easy steps:
Invest early
The longer your money has time to work for you, the more significant the effect of compounding can be. In fact, the effect is far more dramatic the earlier you begin and the longer you stay invested. So, the sooner you can begin investing, the more interest or dividends, and hence growth of your principal, can begin compounding your earnings earlier.
Invest often
Even though periodic or systematic investing does not assure a profit or protect against loss, adding to your investments on a regular basis such as monthly or weekly can help build your wealth quickly. The accumulation builds the base on which your interest is calculated.
To stay on a schedule for periodic investing, some people take part in automatic investment plans, in which money is taken out of their deposit accounts and put into their chosen investments.
Reinvest your dividends
If you own shares in a stock or mutual fund, you may be able to reinvest your dividends into more shares. This continues to build your investment base, allowing you to compound your return. It's putting your new income to work for you.
The same logic should apply to credit unions who also refer to earnings as dividends.
An example
The example below shows the power of compounding, using a 6% rate, which is not typical in all time periods or all investments. Note that as the years increase, the curve gets steeper and steeper. This pattern attests to the way that compounding builds on itself to raise the speed at which your wealth accumulates.
The basic compound interest formula
Compound interest is easy to calculate with a simple calculator. To determine your future return on an investment earning compound interest, use the following formula:
P stands for principal, R stands for your periodic rate of return (interest), and T stands for the number of compounding periods your money is invested. This formula not only calculates the interest on your investment's principal, but also on its prior interest.
For example, let's say you are going to invest $2,000 for 5 years at an annual interest rate of 5%. What will your return be, assuming your interest rate remains the same?
The Rule of 72
There is another simple trick to figuring out how long it will take compounding interest to double your investment. It's called the Rule of 72. Simply divide 72 by your interest rate to come up with the number of years it will take to double.
For example, if your investment earns 6 percent, dividing 72 by 6 gives you 12 — the number of years for your investment to double. To find out the interest rate you will need to double your investment within a certain number of years, divide 72 by the number of years.
For example, let's say you want to double your investment in eight years. Dividing 72 by 8 gives you 9%. This is the interest rate you will need to earn in order to double your investment in eight years through compounding interest.
It should be noted that most investments do not grow at a stable interest rate each year. But these formulas will give you a broad reference for understanding the power of compounding.
Compounded interest and taxes
It will not do you a whole lot of good to compound the interest on your investments only to watch it get taken by the IRS. Fortunately, there are a few ways to compound your interest and avoid paying more tax than necessary.
Compound interest is normally taxable
Unless you invest in a tax-deferred account, you will have to pay taxes on any investment interest at your regular income tax rate. Interest rates paid on savings/checking accounts and bonds, as well as dividends (shared profits), are all generally taxable.
This could mean around 20–35% in both state and federal taxes for those in the United States. So a 10% rate of return could end up being closer to 6% after taxes.
Tax-deferred accounts protect your earnings until withdrawn
A tax-deferred account lets interest accumulate within your account without being taxed until it is withdrawn.
This puts the power of compounding back into your hands, because your investment has the potential to grow faster without taxes cutting into your growing interest. Here are some tax-advantaged strategies to consider:
Tax-deferred retirement plans such as individual retirement accounts
Tax-deferred annuities
A tax-deferred account puts the concept of compounding back into your hands, because your investment has the potential to grow faster without taxes cutting into your growing interest.
Summary of compound interest
Interest earning interest earning interest: that is the power of compounding. Compounding interest can help the value of your investment increase the longer you hold it.
While interest is taxed as regular income, it is possible to soften the tax bite by investing in tax-deferred retirement plans and annuities. To get the most out of compounding interest, invest early, invest often, and reinvest your earnings.
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
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