Compounding wealth is the best way to make your money grow over time. But, it can get a bit confusing for those who are not well versed in financial matters. Here is a quick guide to show you how to start compounding money for those who are considering different investment strategies.
Compounding Returns Explained
The compounding investment definition is an investment that is structured in a way that the returns or interest generated on the principal is added back into the principal to calculate the interest for the following period. So, rather than receiving periodic returns from your investment to spend, you continue to grow the principal, so the amount of interest you earn also grows over time. This helps your investment grow exponentially, rather than steadily increasing at a linear rate. There is more than one compounding interest investment you can choose from, but they all rely on this basic principle.
Think about it like a mortgage. In a traditional mortgage, you make the same payment every month, but as you whittle away the principal, the interest required to pay the bank also decreases. So, over time, the amount of your mortgage payment that goes toward the principal increases, until you’ve paid off the entire loan. Compound interest works the same way, but to increase your wealth, not pay off a loan. The returns are invested back into the principal so that, over time, the interest you earn increases because you’ve now created a larger sum of money to earn interest on.
How to Calculate Compound Interest
The compound interest formula is actually quite simple. You take the principle and multiply it by the interest rate for a given period. Then you complete the same process for each period but adjust the principal amount to include the interest calculated in the previous section. Here is a look at how to calculate compound returns.
The compounding investment formula is: P x (1 + r)t – P, where P = Principal, R = interest rate and t =the number of years interest is applied.
Say, for example, you have $10,000 to invest at an annual rate of 5%. After one year you will have $10,500, because $10,000(.05) = $500. To calculate your return for the next year, you’d take the new principal (10,500) by the interest rate (5%) and you’d get $525, and have a total of $11,025.
To calculate your investment for the third year, you’d multiply the new principal ($11,025) by the interest rate (5%) and you’d get $551.25, which would be added to the principal. You can repeat this process for as long as you like, in order to calculate your total savings over time.
It can get more complicated if you’re adding to the principal beyond just the returns from the investment or your rate of return fluctuates. But, this is the basic concept behind compound interest. If you aren’t good with math or you are looking to analyze a more advanced compounding interest investment, you can always use a compounding investment calculator.
With a compounding wealth calculator, all you have to do is type in your initial investment, your monthly or annual contribution, the time span you’d like to calculate, the estimated rate of return, and any other pertinent information and it will show you exactly how your money will grow over time.
There are a variety of different compounding investment strategies available through reputable financial institutions that rely on this basic principle. So, it’s important to do your research and find one that makes the most sense for your financial situation.
Compound Interest vs Simple Interest
Keep in mind that there is a difference between compound interest and simple interest. Simple interest is calculated only on the principal and does not factor in any interest being added. Simple interest is typically applied to short-term loans and is more straightforward than compound interest. But it can only increase the investment at a linear rate, not an exponential rate, and therefore, it’s not as good for investing.
Simple interest can be calculated as P x r x t.
So, say you borrow 10,000 at an annual rate of 5% and must pay it back within three years. The simple interest on that loan would be 10,000 x 0.05 x 3, which equals $1500.
The compounding investment formula is P x (1 + r)t – P. Although this looks much more complicated when written out, it follows the same pattern as the problem analyzed in the past section. 10,000 (1.05)3 – 10,000 = 1,576.25. Note, this equals $500 + $525 + $551.25, as calculated in the previous section. You can use a compound investment return calculator to continue adding to this problem if you’d like.
Simple interest is typically applied to short-term loans like car financing and personal loans. It makes things simple and easy to understand for both parties because it’s more straightforward to understand what is owed. But, compound interest is better for investing because it allows your money to balloon over time.
In the above example, you’d earn an extra $76.25 in the same amount of time and with the same initial investment, if the investment strategy offers compound interest compared to simple interest. Although it may not seem like much, those extra dollars can snowball over time, especially if you continue to make regular contributions to the principal. This is why most retirement accounts offer compound interest – so you can invest today and reap the benefits in 30 or 40 years.
How Can Investors Receive Maximized Compounding Returns in Retirement?
If you’re wondering how to start compounding money, there are a variety of different options available. Time is the most important variable when it comes to compounding returns. So, the sooner you start investing money in a retirement account that offers compounding returns, the more that money will grow. Those who start investing in a retirement account at 25 will have a substantial sum more than those who start investing at 35, even if the monthly contribution is smaller. This is because they’ve not only been putting in more money, they’ve also been earning interest that the other investor isn’t able to benefit from.
Another smart way to maximize your returns is to contribute either monthly or annually to your retirement savings. The greater the principal balance, the more interest you’ll accrue and the more you’ll be able to benefit from the effects of compounding interest. If you just deposit an initial sum and let it grow, you will see substantial returns over time, but not nearly as much as you would if you’re consistently adding to the principal.
Even if it’s only $50 to $100 per month, this will greatly increase the amount of savings you have for retirement. One way to do this effectively is to automate your savings. Plenty of banks and financial institutions allow you to set up automatic deposits from your checking or savings account into your retirement fund, so you don’t have to even think about it. Just keep it in mind when you’re considering your monthly expenses.
If your employer offers a 401K match, then you are wise to take advantage. This is essentially free money that can be used to boost your retirement savings and take advantage of the effects of compounding interest. You should try to contribute enough to take full advantage of the match because many have a minimum requirement for what they are willing to match.
But the best way to ensure you’re saving enough for retirement is to take stock of your spending habits and develop self-discipline when it comes to your finances. If you feel like you’re not able to contribute enough toward retirement, you may want to consider making a lifestyle change to free up some money. If you want to be sure to maximize your compounding returns, you must think of savings as a priority.
You should consider your retirement savings as a necessary expense along with your mortgage or car payment and live off whatever money you have leftover. If you’re stretched to the limit as it is and can’t afford to downgrade your lifestyle at all, then you may have an income problem.
But the sooner you start investing and the more you contribute early on, the more benefit you’ll benefit from compounding interest. So, if you want to get the most out of your investment, carefully analyze your finances and decide the maximum you can realistically afford to contribute on a regular basis, then stick to that plan as closely as possible.
The Top 3 Common Return Products to Choose From:
There are a variety of compounding investment options available for those who want to begin growing a retirement or investment account. If you’re wondering what are the best compound interest investments, here are the top three compound return products to choose from.
1. Mutual Funds: A mutual fund is a company that pools money from a group of investors and invests it in securities, such as stocks, bonds, and short-term debt. The holdings that the mutual fund collects are known as a portfolio and investors buy shares in the fund. Each share represents investors’ share of ownership in the company and whatever returns it generates.
This is one of the most popular compounding interest investments because mutual funds offer professional management, diversification, affordability, and liquidity. The fund is managed by a financial professional who will understand the market better than the average investor.
They are typically diversified into a wide range of companies and investment vehicles, which helps decrease risk if one investment doesn’t pan out. Mutual funds typically don’t require a high initial investment, making them affordable for beginners and shares can easily be liquidated at any time.
Those interested in compounding wealth should seriously consider mutual funds as a good place to start. There are four different types of mutual funds available: money market funds, bond funds, stock funds, and target-date funds. Each comes with its own risks, features, and benefits and you should carefully research your options before investing in one of these funds.
2. ETF’s: An exchange-traded fund or ETF is an SEC-registered investment company that allows investors to pool their money and invest in stocks or bonds, and receive returns based on the performance of those assets. Mutual funds and ETF’s are similar, but they do feature key differences that are important for investors to consider. Both ETFs and mutual funds are managed by SEC-accredited money managers and offer ways for investors to put money into a diversified pool of stocks, bonds, and other assets.
However, shares in a mutual fund must be purchased directly from the fund itself or a broker, whereas ETFs are purchased on the open market, through the national stock exchange. It’s a different type of compounding investment that offers its own unique advantages and disadvantages. The concept is the same, but the way they are priced and traded differs. Mutual funds are priced according to their net asset value (NAV), which is calculated at the end of the trading day. ETFs are traded according to market prices, which may be higher or lower than their NAV and can be bought or sold any time during the trading day.
ETFs also tend to be passively managed, whereas mutual funds are actively managed. This means that the mutual fund managers are actively studying the market to look for investment opportunities, whereas ETFs are typically invested according to a particular market index, such as the S&P 500. Both are good strategies for compounding your wealth and will allow you to make investments that are vetted by professionals in the industry. But ETFs offer a bit more flexibility and the ability to control your investments, as well as an even lower trading threshold than mutual funds, depending on the product.
3. CDs: A certificate of deposit (CD) is a savings account that contains a set amount of money for a certain period of time that earns interest for the owner. CD’s offer a safe way to save while compounding your money. When you cash out the CD, you will receive the principal, plus any interest you earned on the investment.
CDs offered by an accredited financial institution are insured for up to $250,000. When you purchase a CD, it will require you to leave the money alone for a set period of time which can be anywhere from one month to several years. Each bank or credit union offers different CD rates and penalties for withdrawing early, so it’s important to shop around before committing to one institution.
CDs offer a low-risk way to save money and earn interest. Savings accounts often offer a modest 1% return, but this is often lower than the annual inflation rate – meaning that as your money sits in the bank, it slowly loses its value. CD’s offer a way for you to save while earning interest that will beat inflation. But, they require some discipline and planning, as you won’t have the same amount of liquidity as a mutual fund or ETF. They are also better insulated from the changes in the market. But CDs are perfect for those who are looking to stash away some money for a major purchase and want to be able to earn some interest while preparing for this investment.
Those are just a few of the compounding interest investments available on the open market. But there are other strategies for compounding your money offered by employers as retirement plans. Here is a look at a few of the most popular options.
1. 401Ks: A 401(k) is an employer-sponsored retirement savings plan that allows owners to choose an investment strategy that is typically invested in mutual funds. Employees have their pre-tax income invested in the account and earnings from these investments aren’t taxed until it’s withdrawn. There is also something called a Roth 401(k) that is funded with after-tax money and doesn’t require owners to pay taxes upon withdrawal.
Employees often make contributions to their 401K accounts through automatic payroll withholding and many employers offer programs that will match some or all of those investments. 401(K) accounts are a popular compounding investment strategy because they offer the ability to fund retirement savings directly through an employer with numerous benefits like matching programs. But, keep in mind that this money cannot be withdrawn until you’ve reached retirement age, which the IRS defines as 59.5 years old. Otherwise, you’ll have to pay a hefty penalty, on top of the taxes you must pay when you withdraw.
You can often use your 401(k) account to secure a loan if you need the money and don’t want to pay the penalties, but you’ll still have to have to pay it back with interest. It’s best to create a budget before investing in a 401(k) and make sure you have the funds available to finance your current lifestyle. Otherwise, you’ll just end up depleting your savings with fees and penalties. Overall, 401(k)’s present a simple way for employees to begin compounding money and save for retirement.
2. 403(b): A 403(b) plan is a retirement savings plan offered by public schools, state universities, and certain 501(c) (3) tax-exempt organizations, such as churches and other religious institutions. Like 401(k)s, 403(b) plans allow employees to contribute pretax income to a retirement plan. These plans are often matched by employers and can be deposited directly from an employee’s salary. These two types of retirement accounts are relatively similar and offer an easy way to start compounding wealth for those who are busy working a 9 to 5 job. The major differences are that 403(b)s are only offered to employees of tax-exempt organizations and are typically managed by insurance companies, not mutual funds (although this can vary). 403(b)s also usually offer a lower matching program than the typical 401(k) unless an employee has been with the company for a long time. But, they are another investment vehicle available to those who work in the public school system or for a non-profit organization.
What Are the Risks Involved? Can You Lose Money?
With any type of investing, there are always risks involved, even with the safest investment vehicles on the market. But one of the miracles of compounding interest investments is that the risks are often minimal, while the returns can be exponential, as long as you trust an accredited institution to handle your money.
The amount of risk involved in compounding your money varies depending on the investment strategy you’re using. For instance, CD’s offer very little risk as they are insured up to a certain amount, and interest rates are guaranteed by the bank or credit union. ETFs and mutual funds, on the other hand, present a slightly higher amount of risk because they are vulnerable to the swings of the market. But, if you choose to invest with an experienced and accredited financial institution, they will be diversified and well researched enough to be insulated from those ups and downs. If you scrutinize the daily prices of these investments you may drive yourself crazy. But as long as you’ve done your research, the value will go up over time.
No investment is truly safe from the changes in the market and if there is a widespread collapse, these funds are going to be impacted. In the market crash at the early stages of the coronavirus pandemic, nearly every sector of the financial market was impacted, including those that rely on the principles of compounding wealth. But, the funds that were properly managed bounced back and continued to offer high returns to investors after the temporary setback.
The benefit of compounding your money through professional institutions is that it is much easier to rebound from any downturns in the market, than if you’re just investing on your own. The experience and knowledge that professional money managers offer makes it much easier to minimize risk and maximize returns. But, there’s no such thing as a free lunch and if you want to make money, you’ll have to assume a certain amount of risk. But, compounding your money often allows you to benefit from that risk in a way that outweighs any temporary downturns.
Benefits of Compound Growth
There are a variety of benefits to compounding growth that are important to consider.
- Exponentially Increase Wealth: One of the major benefits of compound growth is that you can increase your wealth exponentially over time, allowing you to double or triple your investment over your lifetime. When it comes to compound interest, timing is everything. The sooner you start saving, the more you can reap the benefits of compounding interest. You can use a simple compounding wealth calculator to see how your investments will explode over time through compound growth and visualize the difference between starting an investment account now and starting in 10 years.
- Better Returns than Simple Interest: While simple interest can be good for some things, compounding interest is much more effective for investors. The difference between linear growth and exponential growth can result in earning thousands, if not millions, of additional dollars over time, depending on the size of the investment. Simple interest is easier to calculate and understand. If you want to truly build wealth, compounding interest is the way to do it. Use a compounding investment calculator if you want to learn how to calculate compound returns vs simple interest returns, and see the difference for yourself.
- Pay Down Debt Aggressively: If you have a lot of debt to pay off, compounding interest is one smart way to increase what savings you have to pay down that debt faster. Compounding interest can work against you if you are not careful. If you have a lot of credit card debt that just keeps ballooning because interest is being added to the principal, it can get overwhelming to try to pay it off just from your paycheck. Instead, what you can do is start investing in a CD, mutual fund, or any of the other compounding interest investments discussed, while still making regular payments. Then, as your investment grows, you can pay down your debt more effectively by using the money that’s been compounded.
- Save for Retirement: Compounding interest investments are great for retirement savings because the longer you wait to use the money, the more you’ll reap the benefits. Compounding interest doesn’t work particularly well for short-term investments where you’ll be looking to cash out in a few months or a year. But, when it comes to retirement savings, where you won’t be touching the money for 30 or 40 years, the benefits of compounding interest are astonishing. So, as long as you are diligent about saving, you can build a healthy retirement account that will double while you work.
Compounding interest is one of the miracles of the financial world. It’s a relatively simple concept that allows investors to build wealth and save for the future with confidence. If you learn how to harness this powerful investment strategy, you can turn modest savings into a fortune over the course of your lifetime.