The Power of Compounding

Now that interest rates have risen to 3%, 4% or more, the power of compounding takes on new meaning for savers and investors. Do you understand how compounding works? Compounding multiplies savings or debt at an accelerated rate. It works in your favor if you are a saver, but it can work against you if you are a borrower.

Compound interest is interest calculated on both the original principal and all previously accumulated interest. Compounding adds earned interest back into the original principal balance of your account, which then earns even more interest on the new higher principal balance, “compounding” your returns. Interest can be compounded at different time intervals depending on the terms of the savings instrument: annually, quarterly, monthly, or daily. The more frequently interest is compounded, the faster your principal balance grows. For investors and savers, compound interest is a positive benefit.

Many savings accounts are set up with compound interest, usually with daily compounding. Certificates of Deposit compounding is typically either daily or monthly. Series I bond interest is compounded semi-annually. Earnings in investment accounts (such as 401(k) retirement plans, IRAs, and investment accounts) also compound over time. For example, the daily percentage that an individual stock gains are calculated based on its performance the previous day. This means the earnings compound each business day. By reinvesting dividends and/or making periodic deposits, your balance will grow faster.

Compound interest is different than simple interest. Simple interest is NOT reinvested into the original principal balance, and accounts with simple interest will not grow as rapidly as compound interest accounts. Simple interest is used when calculating the interest on automobile loans and other short-term debt. As a saver, you should know whether or not your account uses compound or simple interest. This creates a significant difference in long-term total savings. Consider selecting investments and savings accounts that enable you to take advantage of compound interest over time, preferably daily compounding.

Compound interest can help you or hurt you, depending on whether you are saving or borrowing. Credit cards use compound interest daily, which is why credit card principal balances can grow large quickly. Credit card issuers charge interest on the outstanding card balance every month. If you never charge another penny to the card and pay the accrued interest each month, your balance will stay the same and not decline. This works against borrowers who only pay the minimal balance on their credit cards each month. If you don’t pay enough to cover the month’s new interest, the interest is added to your credit card balance.

Student loans, mortgages, and personal loans usually compound interest monthly. As a borrower, you accrue interest on money you do not pay back. For example, if you don’t pay the interest charges within the period stated in your loan, the interest charges are added to your initial loan balance, or “capitalized” and future interest accrues on the new, larger loan balance.

How Daily Compounding Works

Consider the following example to see the power of daily compounding. If you invest $1,000 and the average rate of return = 3%, this account will grow to $1,161.83 in five years and $1,822.07 in 20 years. If the average rate = 5%, the account grows to $1,284.00 in five years and $2.718.10 in 20 years. And with an average rate = 7%, the account grows to $1,419.02 in five years and $4,054.66 in 20 years.

The power of time is everything. The earlier you start saving or investing, the more time your money can grow. That is why financial professionals urge clients to begin investing for retirement or other goals at an early age rather than waiting until later in life. The earlier you start saving, the less of your earnings you need to save. Most retirement funds grow through compounding. BUT – compound interest will work against you when you borrow money – via student loans, credit cards, etc. The faster you can pay down these balances, the less you will owe over time. Compounding can be a powerful motivator to pay off debt as soon as your can so you can begin to invest and save.

If you are not currently working with FPS, we would be happy to talk with you. Questions? We are here to help.

Want to schedule a quick call with me? Click HERE

Click HERE to receive our award-winning newsletter.

Best regards,

Janet Rhodes Friedman, CFP®, CDFA®, MBA

Janet@PlanWithFPS.com

617-630-4978

Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.