Eric RosenbergBy Eric Rosenberg, WCI Contributor

Compound interest is a financial concept where interest is earned on previously earned interest. Even with a fixed interest rate, over time, a savings or investment account balance should grow exponentially thanks to the power of compounding. Here’s a closer look at the ins and outs of compound interest to help you understand how it can supercharge your portfolio.

 

Why Is Compound Interest So Powerful?

“Compound interest is the eighth wonder of the world. He who understands it, earns it . . . he who doesn't . . . pays it.”

The quote commonly attributed to Albert Einstein (though he probably didn’t say it) makes a grand statement about the power of compound interest. There’s truth to the concept that compound interest is a powerful financial force. Understanding how it works can significantly benefit your finances.

As you add interest from the prior period, it’s used when calculating the next period’s interest. While the impact can be small at first, it grows over time. The longer you save or invest, the more you earn each compounding period. The example below shows the impact of compounding over 30 years. Assume someone deposits $10,000 in an investment paying 5% with a monthly compounding schedule.

 

compound interest schedule

 

Over 30 years, a $10,000 investment grows to nearly $45,000. With more savings or a higher interest rate, the effects are even more dramatic.

 

How Do You Earn Compound Interest?

You can earn compound interest on savings or investments. In most cases, compounding is automatic when you use the correct account. Most bank savings and investment brokerage accounts enable you to earn compound interest.

At your favorite bank or credit union, look for high-yield savings accounts, CDs, and money market accounts with high interest rates. High-yield savings accounts tend to offer among the best interest rates around without a time commitment. CD accounts may offer higher rates, but you’re locked in for a specific time period, and you would have to pay a penalty to withdraw before the maturity date.

To earn compound interest from an investment, the trick is picking suitable investments for your goals. Compounding works differently with investments, as you may not earn interest regularly. But as investment growth is measured as percent growth per year, you can apply the same logic as you would with savings accounts.

Measuring growth for a savings account or investment relies on one of a few different formulas. If you know your expected rate of return, you can plug in the initial investment value and calculate your investment results.

More information here:

What You Need to Know About Laddering CDs

 

How to Calculate Compound Interest?

The standard compound interest formula is as follows:

 

compound interest formula

 

Suppose you know your initial balance, interest rate, number of interest periods per year (12 for monthly or 365 for daily compounding, for example), and the number of years you’re saving. In that case, you can plug in your numbers to find your final amount.

If you invest in bonds or other fixed-income securities, the same math applies. With a fixed-income investment, you’ll know upfront what you’ll earn over the investment period.

For other investments, the calculations can be more complex but rely on the same formula. For example, if you buy an investment paying a 2% dividend that you expect to grow 7% per year, you could use 9% as your interest rate when calculating compound interest. This logic applies to stocks, mutual funds, ETFs, and many non-traditional investments. While you have to assume your rate of return or interest rate, your compound interest calculation works the same.

If you’re looking for a trustworthy compound interest calculator, check out this resource from the Securities and Exchange Commission.

 

Can Compound Interest Make You Rich?

Yes! Compound interest can make you rich. To get the best results from compound interest, find a reliable investment and stick with it long-term. The younger you can start investing, the better for your finances. But even if you’re already well into your career, it’s never too late to start.

In investing, steadily putting funds away regularly is another powerful concept. Known as dollar cost averaging, buying into an investment fund (or other investment) regularly, regardless of market ups and downs, typically pays off with substantial long-term returns.

But it’s also essential to understand the risks. If you choose a poor investment or wind up with unfortunate timing, you could lose money despite best intentions.

More information here:

4 Ways to Maximize Compound Interest

 

What Are the Disadvantages of Compound Interest?

The biggest drawback of compound interest is if you’re on the paying side of the equation. While banks and investments pay you, it works the other way when you’re a borrower. In that case, banks and other lenders benefit from you owing interest.

Fortunately, many loans come with no prepayment penalty. If you can pay off your credit cards, car loans, and anything else ahead of schedule, you can avoid paying unnecessary interest to the lender.

 

compound interest

Can You Lose Money in Compound Interest?

Another potential disadvantage is unexpectedly poor returns. While we always hope our investments will outperform and grow in value, there’s always a risk they’ll go the other way. While compound interest works great when investments increase in value, there are no guarantees in the investment markets.

When your funds are in a bank account, they’re guaranteed not to lose value by the federal government. Thanks to the Federal Deposit Insurance Corporation (FDIC), your funds are guaranteed, including interest earned, up to $250,000 per depositor per institution.

 

Don’t Underestimate the Power of Compounding

When you’re just starting, interest earned from bank accounts or growth from small investments may not seem exciting. But when you stick with your saving and investing strategy for years and decades, you’ll potentially see impressive results, thanks in large part to compound interest.

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