By: William Pirraglia
Compound interest can dramatically affect the future value of some investments. Many investments such as stocks do not pay interest, so the positive effect of compounding does not affect them. You earn income on stocks through capital growth, which drives up the stock price. However, whether your investments consist of simple bank savings accounts or corporate bonds, compound interest can increase the value of your portfolio.
Interest on interest
Compound interest means you earn interest on the interest. However, the benefits of compound interest only apply if you leave your interest in your account and don’t spend that income. Compound interest can turn a small initial investment into a larger dollar balance if you let it do what it does best – multiply your dollars.
Future value of dollars
Money historically loses value over time. The future value of a dollar is usually less than its present value. Compound interest can reverse the historic devaluation of every dollar. Rising inflation can lower the future value of money faster than time alone. Compound interest rarely compensates for the typical drop in the dollar’s value in the short term. However, it can counteract this decline over longer periods of time.
Reinvest the effects
Paying your interest income into a different investment generally reduces or eliminates the benefits of compound interest. However, depending on the quality of your new investment, it may generate more income than compound interest. Bonds and real estate investments often earn interest at regular intervals, allowing you to grow your account or use that income to make new investments.
The number of compounding periods in a year and over the life of the investment has a direct impact on the compound interest you receive. The more compounding periods, the stronger the effect on the future value of the investment. The more interest accrual dates, the more the compounding increases your account balance, regardless of your interest rate.
The compound interest formula is “P” multiplied by the following: (1 plus “r” to the power “n” minus 1. “P” is equal to the principal or the initial balance, “r” is equal to the rate d ‘interest of each compounding period and “n” is the number of compounding periods. For example, if you open a $ 1,000 account with a monthly compounding at 12% interest per year, your calculation is 1,000 $ multiplied by the following: 1 plus 0.01 – which is 12% divided by 12 months – to the power of 12, minus 1. This is equal to $ 1,000 multiplied by 0.12683, or $ 126.83 per first year, more than the $ 120 you would earn without capitalization You can use online financial calculators to estimate the future value of your investments that earn interest.