Do you ever get concerned that you may not be able to save enough money for your retirement or your child’s education? Well, why not pick an investment vehicle with compound interest. Luckily, this article will help you understand some of the fantastic benefits of compound interest.
The Amazing Benefits of Compound Interest (And How to Maximize)
Nothing delights an investor more than the magic of compound interest on their savings and investments.
If you want to reap the vast benefits of compound interest, then you must be ready to save and invest your money in investments with compound interest.
There are a few simple ways to help you save enough for your retirement and education.
All you need is the willingness to learn how you can put your money in the right investment vehicles to work for you.
The secret is in the compound interest, and it is the best way to help you exponentially grow your wealth. This is why I’m building a dividend portfolio that continues to be reinvested at various levels no matter what the stock market is doing.
Before we can explore the importance of compound interest, let’s look at a few compound interest facts.
So what is compound interest?
Compound interest means the multiplication of your investment, and it offers you the time value of money. A majority of people look at the interest in terms of interest accumulating when you have a loan.
Well, interest can also be the money that you earn on your savings and investments.
To better get an idea of the benefits of compound interest on your investments and savings, let’s analyze a mathematical equation of compound interest:
A=P (1+r/n) to the power of n*t,
A —which represents the future total investment value, including earned interest
P —represents the initial deposit amount or principal investment
r —which represents the interest rate that is annually and is as a decimal
n —represents the number of times the compounding of interest occurs each year
t — which represents the number of years the investor invests the money for
Benefits of Compound Interest
One of the best quotes about compound interest is from Albert Einstein himself as… ‘the most powerful force in the universe’.
If you save money today, it will put you in a much better position tomorrow. Compound interest is literally magic.
So, some of the benefits of compound interest include:
Compound interest helps exponentially increase the wealth of the investor in the long run
The power of compound interest is one of the best dreams any investor wants to achieve. This is the amount of interest that an investor gets from savings but also on the interest received from their investment.
If you’re going to get the most return on the money you save or invest for retirement, you must start investing early.
Compound interest mainly represents the addition of interest to the deposit. In simple terms, it is the interest on the interest received. It comes as a result of reinvesting interest, instead of paying it out.
The investor gets an interest in the principal sum in addition to the previously accumulated interest in the subsequent period.
An investor accumulates better returns than with simple interest
When it comes to calculating interest, you need to understand the two main types of interest which include the simple and the compound interest.
Unlike the simple interest that is paid only on the principal amount of money that you save or invest, the investor is paid compound interest on both the principle and on the interest.
To fully understand the difference, let’s look at an illustration.
For example, if you invest $100 at 10 percent annual interest. In one year, you’ll have $110 with either simple or compound interest.
Compound interest benefits will begin to manifest in in the second year as well as all the subsequent years for as long as your investment remains intact.
At the end of the second year, you’ll have $120 with simple interest but $121 with compound interest.
Then, after five years, the amounts for simple interest will only be $150 and $161 for compound interest. In the tenth year, the amounts are $200 for simple interest and $259 for compound interest.
After 20 years, the values are $300 for simple interest and $672 for compound interest. In the 50th year, you could have either $600 with simple interest or $11,739 with compound interest.
From our example, it’s evident that the difference between the returns with simple and compound interest widens with time. The examples mentioned above show that with compound interest, the investor gets far much better returns than with simple interest.
How to Maximize the Power of Compound Interest
There are a few ways to maximize the power of compound interest. Here are a few points to consider.
- If you understand the power of the compound interest, it can help you advance your finances. When you know that you can make money from your money, then it should act as an incentive to invest and save as much as you can and to not touch it for as long as you can.
- You need to get started early to maximize this benefit. The power of compound interest is one of the main reasons why most financial planning professionals and retirement experts recommend starting a retirement plan soon.
- Another consideration to check is how often the interest is compounded. Investments whose interest compounds monthly grows faster than the investment with interest that compounds annually. Try to compound your returns as often as possible by continually reinvesting over time.
To maximize the power of compound interest you need to invest with the following characteristics:
- Low to no fees at all; these can erode your benefits over time and just like compound interest these fees can compound too
- A fast, automated way to deploy capital back into your investments
- High frequency of reinvestment the better… Daily compound interest is always better than annual
These all can happen through M1 Finance, a free automated investing platform that allows you to invest directly or completely automated.
You can invest in a portfolio through M1 Finance Pies. Check out a few examples of these Pies to learn more.
I also used a few tools to eliminate fees in my retirement accounts. Fees can grow over time as they are based on assets under management, so as your nest egg grows your fee payments grow too.
Investments with Compound Interest
Every investor wants to make the best returns from their investments. Personal Capital is one of the most amazing net-worth tracking and investment allocation tools I recommend.
The platform charges nothing to use it and can help you keep track your budgeting as well as your investment accounts.
You can utilize it to come up with the best investment accounts. I’m happy to highlight some of the best examples of compound interest in terms of investment opportunities.
Here are some of the best investments with compound interest that you can invest in:
Bank accounts are some of the typical compounding vehicles. One of the key features of most savings accounts is the interest they pay, which will gradually be higher than the interest you can earn on any checking accounts.
In a majority of savings account, the interest compounds monthly or twelve times in a year.
Money market accounts
Money market account is also an ideal investment with compound interest. The interest on money market accounts usually is compounded daily and paid monthly.
The good thing about this compounded interest is that the bank pays you interest on the money they have paid you in interest.
Dividend reinvestment is yet another investment with compounding interest. The compounding in dividends comes from the fact that dividends provide a regular flow of additional income that is reinvested in more shares of stock.
Dividend reinvestment plans (DRIPs) or the company-sponsored direct investment come into play. If the company that you have invested in does not offer DRIPs, then you can do it yourself.
When the investor reinvests their dividends back into the market, the wealth exponentially increases since, in the long run, the dividends reinvestments compounds.
One of the best tools to help you build a dividend portfolio from scratch is by using the Robinhood. You can build wealth through dividend growth investing and also benefit from the compound interests.
If you want to learn more about dividend investments and how to live off dividends, you can get a copy of Millionaire Mob dividend investing book.
Fractional shares which may be as a result of dividend reinvestment plans (DRIPs), stock splits or a similar corporate action also comes with compound interest.
In my video below, you can see that it takes 15 years to make $1 million. However, it only takes 4 years to turn $1 million into nearly $3 million. That is compound interest at work.
You can download my dividend reinvestment calculator mentioned in the video below.
It literally only takes 5 minutes to start inputting your own assumptions!
Fractional share investing is a component of reinvesting your dividends if you use a DRIP program. However, did you know that you can do fractional share investing without using a DRIP. There are plenty of platforms that will invest your money on a fractional share basis as soon as it is contributed to your account.
One platform I’m absolutely in love with is M1 Finance. The platform is completely free and will automatically reinvest any proceeds even with fractional shares.
There are no commissions for trader either. Read more about it in my review of M1 Finance.
You can also utilize the free stock calculator, to help you invest your money wisely.
Certificates of deposit (CDs)
Certificates of deposit (CDs) are another secure form of investment with compounding interest. Though CDs have a lower rate of return than other investments, they offer a higher rate of return on deposit accounts.
The interest is also compounded daily which leads to a higher return over time. When the interest compounds daily, it means that the bank calculates the amount of interest you earned on that day which helps accumulate your balance with time.
This is an example of compound interest not commonly found by retail investors. If you are an accredited investor or invest on a real estate crowdfunding platform, y0u may have exposure to paid-in-kind interest (PIK).
PIK interest is an accruing non-cash form of interest payment. If there is 10% PIK interest on a principal balance of $10,000, then $1,000 will be added to the principal balance at the end of the year.
The next year your principal balance starts with $11,000 and the 10% PIK interest is calculated off that. So, $1,100 of PIK interest is added to $11,000 making the ending year’s balance $12,100 and so no.
There is no cash payment made and it just continues to add onto the principal. You can see why this would be so attractive. However, since the balance compounds at such a rapid rate you better be confident in the borrower’s ability to repay it at maturity.
Conclusion on the Benefits of Compound Interest
Compound interest results in a huge impact on your investments. The resulting benefits of compound interest can boost your finances and help you achieve financial independence.
I suggest that you opt for higher returning ways of benefitting from compound interest such as fractional share investing and dividend reinvestment.
While compounding savings and certificates of deposits are good, they won’t make a meaningful impact over the long-term as something that combines both the benefits of capital appreciation and income.
Share with us some of the investments vehicles that you are using with compound interest in the comments section below.
What are your favorite benefits of compound interest?
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