What is the connection between mutual funds and compound interest?

Mutual funds are popular vehicles that pool money raised from investors. This capital is then invested in securities and assets – stocks, bonds, cash, money market vehicles and others – depending on the profile of the fund, whether it is a small capitalization fund, a fund international fund, a government bond fund, etc. Investors, in turn, earn income on their investments.

But do these vehicles pay interest or dividends? Many do. Plus, they offer investors one of the easiest ways to reap the benefits of compound interest. Read on to learn how you can earn income from your mutual fund investments and how compound interest relates to these financial vehicles.

Key points to remember

  • Compound interest is calculated on the principal amount, plus additional deposits and interest.
  • Mutual funds offer one of the easiest ways for investors to reap the benefits of compound interest.
  • The more money you invest and the longer it stays, the more compound interest you will earn.
  • Reinvesting dividends and distributions also improves your chances of earning more compound interest.

Mutual fund returns

As mentioned above, mutual funds are attractive investments for investors who want to diversify their portfolios. Investors buy shares of a mutual fund or funds that match their financial goals, risk tolerance and lifestyle. The money raised is then used by portfolio managers to invest in other assets, giving investors exposure to a range of different securities.

Thus, a share of a large-cap fund gives investors a small degree of ownership in various companies. Actively managed funds are regularly monitored, with the fund manager reallocating assets to ensure the fund achieves its objectives.

There are several ways that mutual funds pay returns to their investors. First, you can earn money from the dividends of the securities that make up the fund’s holdings. The fund company normally pays income in the form of distributions. You can take them in cash or reinvest them.

Most funds also pass capital gains on to investors as part of a distribution. These gains come from the sale of securities whose price increases. The last way to get a return from a mutual fund is to sell your shares for a profit. You will make a profit if the prices of the securities rise but are not sold by the manager.

Compound Interest Adds Up Quickly

So how is compound interest factored into mutual funds? Remember that compound interest is paid on the accrued interest you earn. Therefore, it is calculated on the principal amount plus additional deposits and interest. You can also think of it as interest on interest. Compound interest allows your balance to grow faster than simple interest, which only takes into account the principal amount.

It’s easy to increase your compound interest as a mutual fund investor. The more money you invest and the longer it stays, the bigger it grows. Choosing to reinvest your fund’s dividends also increases your chances of earning more compound interest. This is because you buy more shares of the fund when you put distributions back into it. More compound interest accumulates over time, and the cycle of buying more shares will continue to help the fund, and its initial investment in it, grow in value faster.

Katie Kerpel {Copyright} Investopedia, 2019.

Reinvest your mutual fund distributions rather than receiving them in cash if you want to earn more compound interest.

Example of Compound Interest

To better demonstrate how compound interest works with a mutual fund, here’s a hypothetical example. Consider an open-ended mutual fund with an initial investment of $5,000 and subsequent ongoing annual additions of $2,400. With an average annual return of 12% over 30 years, the future value of the fund is $798,500.

Compound interest is the difference between cash contributions and the actual future value of the investment. In this case, by contributing $77,000, a cumulative contribution of only $200 per month over 30 years, the compound interest amounts to $721,500 of the future balance.

Are mutual fund distributions taxable?

Yes. If you hold mutual fund shares in a taxable account, distributions, whether paid in cash or reinvested in additional shares, are taxable. These will be reported annually on IRS Form 1099-DIV.

How can I avoid paying taxes on mutual fund distributions?

If you hold a mutual fund in a Roth IRA, capital gains and distributions are not subject to income tax. Distributions and gains are tax-deferred in a traditional IRA or 401(k) plan.

What is simple interest?

Compound interest pays returns both on the amount invested and on all previous returns. Simple interest, on the other hand, pays only on the amount invested in each period. Therefore, compounding allows investments to grow much faster over time than simple interest.

The essential

Compound interest is one of the simplest and most useful concepts in finance. But you don’t have to be rich or a good trader for this to work in your favor. You just need to understand the time value of money and start investing as soon as possible.

The principle is the same whether you invest 20 or 20 million dollars. By adding the interest earned in the initial capital investment, the value of the mutual fund increases at an increasing rate.

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