The Power of Compound Interest!!

You may have heard the phrase "Let your money work for you" and wondered what that means. The simple answer is to invest your money to generate returns. Compound interest has the same concept but operates differently from investing and returns only. Compound interest is the foundation for building your savings and a key driver of gaining wealth over time.

What Is Compound Interest?

Compound interest is the interest you earn on interest. If you have a savings account or a CD earning compound interest, you will earn interest on the initial principal amount deposited, plus the interest that accumulates over time.

Compound interest helps your savings and investments grow faster than with simple interest accounts. For example, if you deposited $1,000 in an account that pays 5 percent annual interest, you will have earned $50 after a year ($1,000 x 5% = $50). In year 2, your beginning account balance is $1,050. Now you will earn an additional 5% annual interest on $1,050, bringing your total to $1,102.50 at the end of year 2 ($1,050 x 5% = $1,102.50). Your interest payment will increase as your account balance grows over the years. The combination of compound interest and monthly deposits in your account will significantly accelerate your savings.

Don't Confuse Compound Interest With Compound Returns.  

Unlike compound interest, which grows at a predictable rate based on a stated interest rate and compounding schedule, stock market returns compound through a combination of price appreciation and reinvested dividends. These returns are not guaranteed and can fluctuate due to market conditions, company performance, and broader economic factors.

Over the long term, however, reinvesting dividends and benefiting from earnings growth can allow returns to build upon prior gains. While this compounding effect can significantly enhance wealth over time, it entails greater volatility and risk than the steady, contractual growth associated with compound interest.

Different Compound Interest Payments And Frequency Sets.

Annual interest payments are not the only way a saver can receive interest payments. Many savings accounts, CDs, money market accounts, and other investment vehicles have different set schedules. The bank determines set schedules. Scheduled payments are available in daily, monthly, quarterly, semi-annual, and annual intervals.

Set schedule payments differ from compounding interest frequency sets: the latter determine how interest is compounded. The interest can be compounded daily, monthly, or annually. This depends on the bank. For example, a money market account may pay interest payments monthly but compound interest daily. Each day, the bank will calculate interest on your account, including any interest you've earned but haven't been paid yet.

How To Get The Most Out of Compound Interest.

1. Start And Save Early

Regarding savings, investments, etc., the longer you have your money in these accounts, the more interest can accrue. The power of compound interest comes from how long you can receive interest payments. The primary key is time. Look at the example below.

Saver 1: Start to save $200 per month at age 25 and earn an average annual return of 5%, compounded monthly over 40 years. Saver 1 could accumulate approximately $305,204 by age 65. This total is achieved through a principal contribution of $96,000 over 40 years, illustrating the long-term impact of consistent saving and compound interest.

Saver 2: Start saving $1,000 per month at age 50, with an initial investment of $5,000, and earn an average annual return of 5% compounded monthly over 15 years. Saver 2 could accumulate approximately $277,858 by age 65. This total reflects $180,000 in principal contributions over 15 years.

Although Saver 2 contributes a higher total principal than Saver 1, Saver 1 ultimately accumulates a larger retirement balance. This outcome highlights the powerful advantage of time and compounding—earlier contributions benefit from a longer compounding period, allowing investment growth to play a more significant role in long-term wealth accumulation.

https://www.moneygeek.com/compound-interest-calculator/ can help you calculate the interest you earn based on the rate, time, and amount invested.

2. APY Rates.

The annual percentage yield (APY) is not the same as the stated interest rate. While the interest rate reflects the return earned only on the original principal, APY accounts for the effects of compounding by including both the interest earned on the principal and the interest earned on previously credited interest.

As a result, APY provides a more accurate representation of an account's true earning potential and offers a clearer basis for comparing savings accounts and investment products. When evaluating options, a higher APY generally indicates greater overall interest earned, making it a more effective metric to track than the interest rate alone.

3. Selecting The Frequency Set of Compounding.

Daily and monthly compounding structures generally provide greater benefits to savers, as more frequent compounding allows interest to be credited and reinvested sooner. When comparing accounts with the same stated interest rate, compounding frequency is an important consideration, as higher compounding can increase overall returns over time.

4. Selecting The Common Saving Instruments.

Banks, credit unions, and brokerage firms offer savings instruments with different interest rates and compounding frequencies. Below are a few examples:

• Banks & Credit Union Money Market Accounts / Savings Accounts: With banks, the standard practice is daily compounding for their savings accounts.

• Bonds: Bond interest is compounded on a semi-annual basis.

• Banks, Credit Unions / Brokerage CDs: Interest can be compounded daily or monthly.

The Takeaway

Compound interest is the foundation for building your savings and a key driver of gaining wealth over time. It is a powerful tool because it can grow your money faster than simple interest accounts. The main power of compound interest is the combination of the length of time and the rate at which you can receive interest payments. Remember, the higher the number of compound frequencies, the greater the compound interest received.

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Collins Wealth Management LLC is a Fee-only, fiduciary Registered Investment Advisor firm. The information herein is intended for educational purposes only and is not exhaustive. Diversification, or any strategy discussed, does not guarantee against investment losses, but is intended to help manage risk and return. If applicable, historical discussions or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial advice. Please consult a legal, tax, or financial professional for information specific to your situation.