The power of compound interest explained • Benzinga
Earning interest remains one of the cornerstones of investing and allows you to earn passive income by placing your money in 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 takes a look at the benefits of compound interest and how it can increase your net worth.
What is compound interest?
Compound interest can best be described as âinterest on interestâ. In other words, the interest you receive on an investment, such as a certificate of deposit, is added to the original principal and subsequently accumulates or âaccumulatesâ additional interest which helps to grow your investment even further.
Compound interest is the result of reinvesting interest earned over a period of time instead of paying it. Thus, the interest paid during the following period is on the initial deposit plus the interest accrued on the account.
For example, if you open an interest-bearing savings account, the interest you receive on the account balance goes into the account and is added to the existing balance. You then receive interest on the accrued interest and on the initial deposit. Interest earned on the principal and interest amounts in the account increases or “compounds” to increase the account balance.
Compound interest can increase the value of your portfolio over time, especially if you primarily hold interest-bearing investments like certificates of deposit or bonds. By increasing the value of your portfolio by receiving both interest and compound interest, the amount of your equity held in these instruments should increase over time.
Where do you meet compound interest?
You often see compound interest in the different types of savings accounts that you can open at most financial institutions. You might also see compound interest paid on fixed income securities like bonds.
Note that interest can be compounded on any frequency schedule. Common examples of dialing frequency include daily, monthly, and annual dialing. You might even find a continuous composition.
Additionally, the number of compounding periods can dramatically affect the amount of interest you earn over time. Be sure to check how often the 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 take advantage of compound interest or a similar benefit are listed below.
One of the safest and most readily available ways to earn compound interest is by using a high yield savings account. This type of investment may be suitable for people with a stable income who make frequent deposits into the account. To maximize your returns, choose a savings account that compounds interest daily rather than weekly or monthly, as your account balance will grow faster. Plus, having your money in a savings account at a bank usually gives you immediate access to your funds in an emergency.
- Money market chequing accounts
A current money market account usually pays compound interest. It also allows you to write checks and withdraw money using an ATM card, although you may have a limit on the number of transactions you can make each month, and fees. you may be charged if your balance falls below a certain amount. Since money market accounts typically pay a very low interest rate, it probably makes more sense to diversify your investments into higher yielding assets if you plan to increase your net worth through compound interest.
Bonds are units of securitized corporate debt that companies issue and pay a fixed rate of interest. The return on your interest on 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 may carry more risk and less liquidity. The bonds with the highest yields are typically short-term corporate bonds that mature in less than a year and zero coupon bonds that sell at a discount and must be held to maturity. to get the full benefit of interest. You can get an aggravated effect by reinvesting the bond coupon payments in more bonds.
A stock is an investment that represents a share of ownership in a company. Many stocks provide regular dividends which consist of money the company pays out to its shareholders from its profits or reserve funds. If you reinvest those dividends in the stock, it has a cumulative effect. Dividend stocks generally have a higher risk than other compound investments because stocks can rise or fall in value. If you think the market is fair and select a dividend paying stock with good fundamentals, then you could benefit from capital appreciation as well as compound dividends. You can also choose preferred stocks which may not be as liquid as common common stocks, but they could offer higher dividends and greater security in the event of a business wind-up.
Composition makes your money grow faster
When you deposit funds into an account or investment with compound interest, your money grows faster because you earn interest on your new balance that includes previously paid interest. Below is a formula that tells you how much your capital balance will amount to (P ‘) based on the initial capital amount P:
P ‘= P (1 + r / n) ^ nt
P ‘= the new principal amount
P = the amount of the initial deposit or the principal
r = the annualized nominal interest rate expressed as a decimal number
n = how often 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 amount of the initial deposit (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 into a savings account with monthly compounding at an interest rate of 2% per month. 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 to 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 principal of $ 50,000 at an annual rate of 2% per year compounded 12 times per year over 5 years is $ 55,253.94. Note that compounding interest gives you $ 253.94 more than the $ 55,000 you would have received without compounding.
As you can see from the example above, receiving compound interest increases your money over time compared to what you would have made on an investment that only earns simple interest. Plus, if you receive compound interest more often, you receive even higher interest to help your money grow faster.
Choose compound interest over simple interest
Compound interest can be very powerful when you are investing or saving your money over long periods of time. Now that you know how much better it is to get compound interest over simple interest, you will probably want to look for compound interest to earn 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.
Frequently Asked Questions
How do you compose the interest?
How do you compose the interest?
By putting your money in an investment that earns compound interest, you earn interest on the interest paid to you. The more frequent the capitalization, the more you will earn compared to a similar investment that only pays simple interest.
What is an example of compound interest?
What is an example of compound interest?
If you open a savings account with a deposit of $ 50,000 at an annual interest rate of 2% compounded monthly, you will increase your account balance from $ 5,253.94 to $ 55,253.94 over a period of time. of 5 years. This increase in balance includes the payment of interest on the interest you have already paid. Compound interest will increase your interest income by $ 253.94 to $ 5,253.94 from the $ 5,000 you would have received in simple interest without capitalization.