Would you rather earn interest – or pay it? Understanding how compound interest works allows you to make better decisions about your investment portfolio and your overall financial life.
Compound interest is the ability of your money to earn interest on interest. Contributions to a 401(k) retirement plan demonstrate this perfectly. Suppose you opened a 401(k) account and deposited $19,500 each year (the maximum allowable contribution for 2020 for people under 50) and earned 10% per year. In eight years, you would be earning $22,000 a year interest alone.
In other words, the amount you would earn in annual interest would exceed the maximum contribution you could contribute each year.
But compound interest also has a dark side. Debt can accumulate just as efficiently as investments – and if you have high-interest debt, it can quickly spiral out of control as more and more interest accumulates each month.
Wondering how to use compound interest to your best advantage? Here are three ways compound interest can work for you:
- Interest earned.
- Dollars invested.
And three ways it can work against you:
- Have high interest rate debt.
- Overspending in your portfolio.
- Take advantage of tax-deferred accounts.
Compound interest can increase your wealth
Interest earned. Where can you earn interest? Bonds, of course. You may also experience some degree of capitalization in your savings account (generally, online banks offer higher interest rates than physical banks).
Dividends from stocks and distributions from mutual funds aren’t technically “interest,” but they are a form of income that accumulates in your portfolio. Basically, any growth in your portfolio provides a larger asset base for compound interest to work its magic.
Time. The longer your money is invested (and/or earning interest in a savings account), the longer it should benefit from compounding. Every year your interest grows on itself, that’s more money in your pocket.
The best time to start saving and investing is always now! Don’t be frightened by current market conditions or your thoughts on what might happen with markets or interest rates in the future.
Design an investment allocation that suits your long-term goals, ensure your cash reserves are maintained at appropriate levels – and get started.
Starting as a saver and investor at a young age also gives you other unique benefits. Having a longer investment timescale means you can afford more risk (e.g. stocks and other higher risk/return assets), since you will have plenty of time to recover from a market downturn. Remember that with higher risk comes higher potential return (and vice versa).
Dollars invested. It may seem obvious… but money makes money. If the amount you have invested is limited, the benefits of compounding will also be limited. Automate your contributions to savings and investment accounts to put you in a strong position to benefit from compound interest.
Compound interest can reduce your wealth
If you owe money, compound interest means you pay interest on the interest. This is obvious when you first take out a mortgage – for a long time your monthly payments go mostly to interest and very little to principal repayments.
Have high interest rate debt. Credit cards often come with high interest rates. It can be extremely difficult to get out of a hole when you are constantly paying interest on interest. Prioritize paying off your largest debts first.
Overspending in your portfolio. Excessive investment fees erode your investment returns. To give a very simple concrete example, let’s compare two mutual funds that track the S&P 500 – their investment methodology is designed to be identical.
One of them is available at a low cost of 0.015% and the other at 0.5% per annum. The performance of the low cost fund over the past 10 years was 269.21%, while the performance of the most expensive fund was 252.44%.
Wouldn’t you rather have an extra 16.77% in your wallet? As your portfolio grows, the more expensive fund will eat into your returns faster.
Tap into your tax-deferred accounts. When you withdraw early from your tax-deferred accounts, you not only pay a 10% penalty, but you also give up the ability of those dollars to accumulate over time. It really adds up!
The same goes for a 401(k) loan, to a lesser extent. It’s not as devastating because the interest you pay is for yourself, but you don’t benefit from investment growth during the time your money isn’t in the plan.
If that withdrawal is from an Individual Retirement Account, it’s a double whammy. You reduce the remaining dollars in your wallet available to earn interest, and you also pay taxes. One of the biggest benefits of a traditional IRA is tax-deferred interest (keeping dollars growing and compounding in your pocket for as long as possible, and delaying paying Uncle Sam).
As you can see, the power of capitalization can have a significant impact. You can make a huge difference to your long-term financial success by taking advantage of compound interest and limiting compound interest payments.