Interest is money paid at a regular interval for the use of money — yours or someone else’s. Handling your personal financial investments correctly includes understanding why compound interest is preferable to simple interest.
As a general rule, money is earned off of the principal amount plus previous interest accrued, meaning your compound interest investments will grow quicker. Alternatively, simple interest is simply the principal balance multiplied by the interest rate, meaning simple interests payments will not increase debt owed as a borrower.
Compound and simple interest should be leveraged differently depending on the situation to make sure your money is making you more money and not draining your wallet.
An Investor’s Best Friend: Compound Interest vs Simple Interest
Compound interest is extremely powerful, but as outlined above, is only preferable to simple interest when you’re earning interest rather than paying it. Albert Einstein phrased it this way:
Calculating Compound Interest
Compound interest is calculated using the formula A=P(1+r/n)nt where A is the total amount (principal plus interest earned), P is the principal, r is the interest rate (written as a decimal), n is the interval at which interest compounds per year (1 for annually, 4 for quarterly), and t is the number of years your money has been invested.
Compound interest compounds at a regular interval, anywhere from daily to monthly to quarterly to biannually to annually. As an investor, the more often your funds compound, the more money you will make.
Visualizing the Power of Compound Interest
Here is a breakdown of how long it would take to reach just shy of $1,000,000 by investing $12,500 a year with and without compounding to demonstrate the potent effect of compounding interest.
|Year||Savings||Contributions||Growth (No compound interest)||Year End Balance|
|Year||Savings||Contributions||Growth (Compound Interest)||Year End Balance|
In the above breakdowns, it takes almost half the time to achieve just shy of $100,000,000 with a very small compounding interest rate of 3%. The average U.S. stock market return over the last century or so has been somewhere around 8-12%, so growing your money into $1,000,000 can happen much quicker than the charts suggest.
But compound interest doesn’t just benefit stock market investors. Below, you’ll find examples of compound interest (or compound-interest-like effects) at work in various different types of investments.
9 Times Compound Interest is Better than Simple Interest
1. High-yield savings accounts
As discussed above, compound interest is incredibly beneficial when you’re investing money. When you put your money in a bank account, you’re technically loaning that money to the bank for them to use elsewhere. Because of this, the bank pays interest on the money you’ve secured in their accounts. High-yield savings accounts earn a higher interest rate than other types of savings accounts and are lower risk than more volatile investments such as stocks. Another benefit to high-yield savings accounts is that transfers and/or withdrawals are quicker and easier than other investments. Compounding interest with high-yield savings accounts allows the cash you set aside to grow more expeditiously than if the account only accrued simple interest because you make gains on both the principal and the interest.
2. Dividend stocks
Dividend stocks don’t generate compound interest in the traditional sense, but they do generate compound interest if the dividend is reinvested by purchasing more stock. Dividends are shares of a company’s profits that are paid out to investors over a regular cadence throughout the year (typically quarterly). Over time, the ownership of more shares would compound the stocks’ “interest” (its dividend payments) by generating more dividend payments, which could then be used to buy more stock continuously. Though dividend stocks don’t directly generate compound interest, the power of compounding still benefits stock investing.
3. High-yield bonds
Bonds are debt securities given in exchange for capital. You can think of them as an IOU: you pay me (a company or government) $5,000, and I give you a bond with the promise that I will pay back the full amount of principal you lent me plus interest. The interest is paid over a predetermined timeframe and the initial investment is returned at the time of maturity (at the end of the set time period). High-yield bonds are issued from borrowers with a lower credit rating, which creates more risk for the lender. To compensate, issuers of high-yield bonds offer higher interest rates. When these high rates of return compound, more money can be made (though notably alongside greater risk).
4. Real estate investment trusts
Real estate investment trusts (or REITs) can be thought of similarly to dividend stocks in that they don’t produce compound interest inherently, but rather “create” compound interest when REIT dividends are reinvested. REITs are funds that allow investors to put their funds in large-scale real estate projects. They can pay out quarterly or even monthly, and when the payouts are reinvested, more real estate is owned and therefore compounding interest is created because the REIT shares generate more REIT shares.
5. Long-term stock investing
Similar to dividend stocks, long-term investing doesn’t pay actual compound interest. But over time, the effects of the company growth you hold stock in is similar to compound interest. As the corporation grows, the stock prices increases accordingly. However, purchasing single stocks or holding them for short periods of time will not provide the same benefits as compound interest. It’s also worth noting that stocks can lose value, meaning returns are not assured like they are when utilizing other types of investments which generate actual compound interest.
6. Money market accounts
Money market accounts are savings accounts that yield a higher interest rate than traditional savings accounts. These money market interest rates are variable and increase or decrease according to inflation. Money market accounts differ from high-yield savings accounts in various ways, including that high-yield savings accounts can require direct deposits. Compound interest generates better returns for investors who take advantage of money market accounts.
7. Peer-to-peer investing
Peer-to-peer (or p2p) investing is loaning money directly to borrowers. The interest earned is the price of the risk Interest rates are so much higher with p2p lending than with other types of investments because the overhead to run the p2p platform is so much lower, and because there can be greater risk involved with lending to peers rather than a bank. Because rates of return are higher, p2p investors benefit from compound interest to multiply their funds exponentially.
8. CDs (certificates of deposit)
As stated by Investor.gov, a certificate of deposit (CD) is a savings account that holds a fixed amount of money for a fixed period of time, such as six months, one year, or five years, and in exchange, the issuing bank pays interest. After the predetermined amount of time, you cash in your CD and are given the principal amount plus interest earned. CDs have the benefit of being insured up to $250,000 when issued from a federally insured bank (though some CDs can be issued by brokerage firms). If you invest in a CD with compounding interest, you will receive interest on the original payment amount plus interest on previous interest accrued.
9. Treasury securities
Treasury securities are a collection of securities issued by the U.S. Department of the Treasury. These investments are typically considered some of the least risky because they are backed by the government. As noted with high-yield bonds, treasury securities accrue interest that compounds at a regular interval. Investors who purchase treasury securities profit from compounding interest on their principal purchase.
Though this isn’t an exhaustive list, it’s worth noting that many investments benefit from compound interest. If these investments only generated simple interest or simple-interest-like effects, gains would not be as high or received as quickly.
Compound interest is also an essential part of your retirement portfolio. In addition to the investments discussed in the above list, retirement accounts such as a Roth IRA or a 401k grow through compounding. Compounding is a tool used to drive your retirement investments.
Compound Interest vs Roth IRA and How They are Used Together
There are plenty of pieces to the personal finance puzzle, and as noted above, different strategies or investments rely on various economic principles to work correctly or more efficiently. When it comes to government retirement accounts such as a Roth IRA, compound interest is an integral part of their appeal.
Compound interest is an economic principle and a Roth IRA is a retirement account. Roth IRAs utilize compound interest to grow exponentially because interest is accrued on both the principal amount invested and previous interest earned, rather than just the principal amount.
A Roth IRA is an individual retirement account that can be contributed to after taxes that allows for tax-free withdrawals. The money earned while invested in a Roth IRA is compounded, which means that less money needs to be invested upfront by the investor to achieve a specific savings goal. This is because compound interest makes up for the savings differential “for free” (i.e. without any work on the investor’s part).
Compound Interest vs 401(k) and How They are Used Together
The relationship between compound interest and 401(k)s (traditional or Roth) is identical to to the relationship between compound interest and a Roth IRA.
Compound interest is an economic principle and a 401(k) is a retirement account. 401(k)s utilize compound interest to grow exponentially because interest is accrued on both the principal amount invested and previous interest earned, rather than just the principal amount.
A 401(k) is retirement savings plan offered by employers in the US. Contributions can be made pre- or post-tax (traditional or Roth), and withdrawals can either be tax-free or taxed (depending on the contribution type). This means less money needs to be invested upfront by the investor to achieve a specific savings goal because compounding interest makes up for the savings differential “for free” (without any work on the investor’s part).
Understanding compound interest, when it’s used, and how it differs from simple interest is crucial to making sound personal finance decisions.
Climb on, FinBase.