Reinvesting your interest earnings into your investments is a powerful way to maximize your return. The effect of compound interest on your investments is especially impactful over a longer time horizon.
Compound interest is different than simple interest. Simple interest is the interest you earn on your original principal only. Compound interest is the result when interest is added to both the principal and the most recently earned interest. In other words, compound interest is interest you earn on your interest.
How does this translate into your pocket?
If you invest $100,000 earning 5% simple interest per year, this would result in $5,000 a year in interest and $15,000 after 3 years. Therefore, at the end of 3 years you would have $115,000.
But if you invest $100,000 with annual compounding interest of 5%, this would result in a total account value of $115,762.50 after 3 years.
Over time this additional earning can add up to a significant amount.
LONG-TERM IMPACT OF COMPOUND INTEREST
The benefits of compound interest become more apparent when looked at over a long period of time. This is part of why it is so important to begin investing at a young age.
The downside of compound interest
Just as compounding interest can help you grow your savings, it can work against you when paying off debt. Some credit cards compound interest daily on your balance. This equates to a higher interest amount due when you carry over balances month-to-month. Mortgages, on the other hand, do not usually have daily compounding interest. As long as your mortgage payment covers the accrued interest, the interest shouldn’t compound.
How to maximize compound interest
Compound interest can help you earn a higher return when carefully applied. The starting balance, frequency, interest rate, and time all affect how much of a return you will see. More frequent compounding periods (such as daily) will amass greater returns. The longer your investment time horizon is and the higher the interest rate, the greater the growth as well. Evaluate your investments with a financial advisor to see if you have opportunities to increase your earnings. You can also calculate compound interest using our online calculator to see how it can impact your investments over time.
Click here to Try The Compounding Calculator
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