Understanding Compound Interest and Its Impact on Your Financial Goals
Anyone involved in financial matters of any kind will have to deal with interest, either working for or against you. A quote often attributed to Albert Einstein provides readers with insight into the benefit or crutch of interest in your financial strategy. He supposedly said, “Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pays it.” However, compound interest is not the only type of interest. There are two primary kinds of interest, Simple Interest and Compound Interest. What is the difference?
Interest earned on initial investment or principal. This interest generates the same yield every year. Say you invested $50,000 at ten percent. Your yield at the end of the year would be $5,000. The following year it would be $5,000 and so forth. i
Interest earned on the initial principal and on top of the interest already accumulated. This strategy is considered the time value of money. In this hypothetical example, say you invested $50,000 at ten percent. Your yield at the end of the year would be $5,000. But this is where compound interest begins to benefit you. In year two, you add the interest earned to the principal, so you now have $55,000 invested at ten percent. The yield at the end of the second year would be $5,500. $55,000 + $5,500 = 60,500. In year three, you have 60,500 invested at ten percent. At the end of year three, your yield would be $6,050. Do you see how compound interest works? ii
Time is on your side:
To make compound interest work for you, investing as soon as possible allows time to assist in growing your wealth. Time is a critical component of the compound interest formula. The younger you begin, the more time the money gets compounded and the greater the return.
Which one is valuable to me?
The value, or benefit to you, of these two types of interest lies in their differences. Simple interest may be more attractive to a borrower because you are not paying interest upon interest. Repaying debt with simple interest is less difficult. However, if you are an investor, compound interest would probably be of more interest to you because of the potential to build greater wealth over time.
How can compound interest be applied?
Bonds, Money Markets, G.I.C.s, etc. – A low-risk instrument:
Money market: This instrument involves purchasing and selling large volumes of very short-term debt products. This can be accomplished by purchasing a mutual fund, buying a Treasury bill, or opening a money market account at a bank. iii
Bond: A fixed-income instrument representing a loan made by an investor to a borrower, a debt instrument. In theory, a bond can be looked at as an I.O.U. Bonds must be paid back at their maturity dates to avoid default. iv
Guaranteed Investment Certificate (G.I.C.): You lend an agreed-upon amount of money to a financial institution for a set time ranging from one month to ten years. These are low-risk investments that hedge against market volatility. v
Exchange-Traded Fund (ETF) – ETFs are pooled investment securities that operate like mutual funds. They track a particular index, sector, or other asset and can be sold or purchased on a stock exchange, unlike a mutual fund. ETFs also can be structured to meet your investment needs. vi
Dividends – Monthly, quarterly, or annual payments to you from a portion of a company's earnings. These dividends get paid out as cash or as additional stock that can be reinvested, called a DRIP program (see below). vii
Dividend Reinvestment Plan (DRIP) – A program that permits investors to reinvest their cash dividends into additional shares of stock. This technique allows investors to compound their returns over time, accumulating dividends that have the potential to turn around and possibly pay dividends to be reinvested. Remember that dividends paid into DRIP programs are taxed as ordinary dividends, even though they are used to purchase shares. viii
Farmland – Investing in farmland is becoming increasingly popular. As of 2022, there are approximately 911 million acres of farmland in the United States. Investors are becoming more interested in farmland because of the steady returns. Farmland benefits from inflation since that would increase acreage values and crop income. ix
There are other ways you can use compound interest to grow your wealth, for example, investing in real estate, or even starting your own business. Working with an experienced financial professional can help you sort through the complexities and challenges you might encounter trying to do it on your own, helping you to potentially save time, stress, and costly mistakes.
This material was created for educational and informational purposes only and is not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
Fund value will fluctuate with market conditions and it may not achieve its investment objective.
An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.
The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
This article was prepared by LPL Financial Marketing Solutions.
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i What Is Simple Interest? (thebalance.com) ii Compound Interest: Explained With Calculations and Examples (investopedia.com) iii What Is the Money Market? (investopedia.com) iv Bond: Financial Meaning With Examples and How They Are Priced (investopedia.com) v The Global Industry Classification Standard (GICS) - classification.codes vi What is an ETF (Exchange Traded Fund)? | iShares vii Dividend Definition (investopedia.com) viii Dividend Reinvestment Plan (DRIP) Definition (investopedia.com) ix Investing in Farmland: A Real Estate Investor's Guide | The Motley Fool