Does compound interest affect the future value of an investment? | Finance

By: William Pirraglia

Compounding can increase the value of investments that earn interest.

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Compound interest can significantly affect the future value of certain investments. Many investments such as stocks do not pay interest, so the positive effect of compounding does not affect them. You earn income on the stock through capital growth, which drives up the stock price. However, whether your investments consist of simple bank savings accounts or corporate bonds, compound interest can increase the value of your portfolio.

Interest on interest

Compound interest means you earn interest on interest. However, the benefits of compound interest only apply if you leave your interest in your account and do not spend that earnings. Compound interest can turn a modest initial investment into a larger dollar balance if you let it do what it does best: multiply your dollars.

Future value of dollars

Silver historically loses value over time. The future value of a dollar is usually less than the present value. Compound interest can reverse the historical devaluation of every dollar. Rising inflation can drive down the future value of money faster than time alone. Compound interest rarely compensates for the typical decline in the value of the dollar in the short term. However, it can counteract this decline over longer periods.

Reinvestment effects

Putting your interest income into a different investment generally reduces or eliminates the benefits of compound interest. However, depending on the quality of your new investment, it may generate more income than compound interest. Bonds and real estate investments often earn interest at regular intervals, allowing you to grow your account or use those earnings to make new investments.

Capitalization periods

The number of compounding periods in a year and over the life of the investment directly affects the compound interest benefits you receive. The more the periods are compounded, the stronger the effect on the future value of the investment. The more interest dates, the more compounding increases your account balance, regardless of your interest rate.

Formula

The formula for compound interest is “P” multiplied by the following: (1 plus “r”) to the power of “n”, minus 1. “P” equals the principal or original balance, “r” is equal to the compounding period interest rate and “n” is the number of compounding periods. For example, if you open a $1,000 account with monthly compounding at 12% interest per annum, your calculation is $1,000 multiplied by the following: 1 plus 0.01, or 12% divided by 12 month, to the power of 12, minus 1. This equals $1,000 multiplied by 0.12683, or $126.83 in the first year, more than the $120 you would earn without compounding. You can use online financial calculators to estimate the future value of your interest-earning investments.

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