How to Make The Power of Compounding Interest Work for You
by: Katherine Santiago
Compound interest is a very powerful concept in the world of finance. If you want to take control of your pathway to financial success, you really need to understand how it can work for you. For investors, this strategy of reinvesting your interest back into your account can even double your investment sooner than anticipated.
What does it mean to compound interest?
Compound interest can be applied to both loans and investment accounts. In simple terms, compound interest can be defined as “interest on interest”. This is interest that is being added onto an account’s initial balance (often referred to as the principal balance). The frequency at which interest can be compounded can range from daily to annually. Banks, for example, typically compound returns daily for savings accounts.
Calculating compound interest
To calculate compounded interest, use the following formula:
P (1 + [ r / n ]) ^ nt
- P: The principal amount of the loan or investment
- r: The annual interest rate in decimal form
- n: The amount of compounding periods per year (for example, monthly is 12 and weekly is 52)
- t: the amount of time (in years) that your money compounds
The power of compounding interest over time
Larry Hickernell, Senior Investor Success Manager at DLP Capital Partners says, “Compounding interest is an incredibly powerful tool used to multiply an investor’s return over time. By reinvesting the distributions they receive (their interest) back into their investment rather than taking their distribution as income in the form of a check or direct deposit into their account, the investor’s balance can grow substantially over time.”
Let’s say for example, you make an investment of $100,000 (your principal) at a return of 10%, compounded monthly for 10 years. If the investor received 10% per year, but took out all their earned interest, they would have earned $100,000 in interest and their principal balance will have remained at $100,000. However, if the investor reinvested all of their monthly distributions at that same 10% for 10 years, they will have earned $170,704.15. Their principal balance at the end of the 10 years will have been $270,704.15. So, as you can see, compounding will have yielded an additional $70k+ vs if they took the payments each month.
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