In a world of instant gratification, investing is one of a few situations where people are forced to be patient. That’s because the power of investing lies in the accumulation of compound interest, which only works if you give it time. If you’re ready to commit to a long-term relationship, here’s what compound interest can do for your investments.
What is Compound Interest?
Compound interest is the process of your money earning money through the cycle of re-investing interest back into an interest-bearing account. For example, say you’re keeping your emergency fund of $10,000 in a high-yield savings account, earning 1% interest per year. At the end of year one, you’ll have $1,100, then in year two, you’ll be earning interest on the initial investment plus previous interest earned. After five years, you’ll have a total of $10,510.10.
As you can imagine, larger investments and interest rates will paint quite a different picture with how much you can earn with compound interest. For example, if that same savings account was an investment earning 5% interest, the 5-year total would look closer to $12,762.82 for no extra effort on your part.
Ways to Increase the Effects of Compound Interest
There are many levers you can pull to amplify the effects of compound interest, including:
Initial Investment:
A larger principal investment means you’ll start earning more interest from the start. If you can, begin new investments with as large a lump sum deposit as possible, then rely on contributions to accelerate growth.
Ongoing Contributions:
Recurring contributions can massively accelerate the growth of accounts, regardless of interest. Committing to a regular recurring investment, whether weekly, monthly or annually, can dramatically change your predicted investment returns for the better.
Interest Rate:
Higher interest rates produce more interest over time. Some investments, like a Certificate of Deposit (CD), may lock in a fixed interest rate, so you’ll know exactly how much you’ll earn when the investment is up. Other investments, like stocks and bonds, have a variable interest rate that’s more difficult to predict.
Compounding Frequency:
Interest accrues differently in different types of accounts. For example, some accounts compound interest daily, monthly, quarterly, or annually and pay it out in one of those terms. Accounts that earn interest daily will generate more income over time than those that compound monthly, quarterly, or annually. Therefore, when you open a new account, look for products that compound as frequently as possible.
Investment Horizon:
Compounding takes time, no matter the frequency. Investments left alone for years or even decades have the most potential to accrue compound interest. That’s a big reason why savvy investors start saving for retirement young. They know that given more time to work, compound interest can help them reach retirement goals much faster than contributions alone.
Withdrawals:
Just like contributions can help accelerate the pace of compound interest, withdrawals can stop it in its tracks. Certain accounts that pay dividends offer to send a check to investors instead of re-investing. If you’re looking to make the most of compound interest, it’s wise to choose to re-invest those gains, which in turn increases your earning potential in the future.
The Bottom Line
Tools like this compound interest calculator from investor.gov can help you understand how changes to your initial investment, monthly contributions, interest rate, and more can impact your estimated investment returns in the long run. As with any significant financial decision, working alongside a financial professional before you invest can be wise. Above all, remember that compound interest works best when given space and time, so planning to invest for years or decades can help ensure maximum potential growth.