The power of compound interest explained • Benzinga

Earning interest remains one of the cornerstones of investing and allows you to earn passive income by putting 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 examines the benefits of compound interest and how it can increase your net worth.

What is compound interest?

Compound interest can be described as “interest on interest”. In other words, the interest you receive on an investment like a certificate of deposit is added to the original principal and subsequently accrues or “earns” additional interest which helps grow your investment even further.

Compound interest comes from reinvesting interest earned for a period of time instead of paying it. So the interest paid in the next period is on the original deposit plus any accrued interest on the account.

For example, if you open an interest-bearing savings account, the interest you receive on the account balance is credited to the account and added to the existing balance. You then receive interest on the accrued interest and on the initial deposit. Interest earned on principal and interest 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 hold mostly 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 net worth held in these instruments should increase over time.

Where do you encounter compound interest?

You often see compound interest in the different types of savings accounts 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 yearly dialing. You might even find continuous composition.

Additionally, the number of compounding periods can have a significant impact on the amount of interest you earn over time. Be sure to check how often interest is compounded when you intend to make a long-term investment that pays compound interest. Compound interest can be obtained from a number of different types of investments. Several common investments where you can enjoy compound interest or a similar benefit are listed below.

  • High Yield Savings Accounts

One of the safest and most readily available ways to earn compound interest is to open 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 since your account balance will grow at a faster rate. Additionally, having your money in a savings account at a bank usually gives you immediate access to your funds in case of an emergency.

  • Money Market Chequing Accounts

A money market checking account typically pays compound interest. It also lets you write checks and withdraw cash using an ATM card, although you may have a limit on the number of transactions you can make each month, and fees. 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 securitized corporate debt securities that companies issue that pay a fixed rate of interest. Your bond interest yields can vary significantly 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. Bonds offering the highest yields are generally 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 benefit from the full interest. You can achieve a compound effect by reinvesting 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 that 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 compared to other compound investments because stocks can go up or down in value. If you call the market right 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 stock, but which could provide higher dividends and greater security in the event of a company liquidation.

Compounding makes your money grow faster

When you deposit funds into a compound interest account or investment, your money grows faster because you earn interest on your new balance that includes interest previously paid. A formula that tells you how much your principal balance will increase to (P’) based on the initial principal amount P appears below:

P’=P(1+r/n)^nt

Or:

P’ = the new principal amount

P = the initial amount of the deposit or the principal

r = the annualized nominal interest rate expressed in decimal

n = how often interest is compounded per year

t = the number of periods elapsed in years

The total amount of compound interest (I) generated by this investment is then equal to the new principal amount (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 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 into 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 in principal and interest on principal of $50,000 at an annual rate of 2% per annum 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 gotten on an investment that only pays simple interest. Plus, if you get compound interest more often, you get even more interest to help your money grow faster.

Choose compound interest over simple interest

Compound interest can be very powerful when investing or saving your money for long periods of time. Now that you know how much better it is to get compound interest than simple interest, you’ll probably want to look into compound interest to get interest paid on your interest so you can grow your savings as much as possible. As always, check back on Benzinga for more useful financial information.

Frequently Asked Questions

How do you compound the interest?

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How do you compound the interest?

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Jay and Julie Hawk

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By putting your money in an investment that pays compound interest, you earn interest on the interest paid to you. The more frequent compounding, the more money you will earn compared to a similar investment that only pays simple interest.

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What is an example of compound interest?

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What is an example of compound interest?

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Jay and Julie Hawk

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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 5 years old. This balance increase includes paying interest on any interest you have already received. Compound interest will increase your interest income by $253.94 to $5,253.94 compared to the $5,000 you would have received in simple interest without compounding.

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