Compound interest

How Compound Interest Helps or Hurts The smartest investor

Would you rather earn interest – or pay it? Understanding how compound interest works helps you make better decisions about your investment portfolio and your overall financial life.

Compound interest is the ability of your money to earn interest on interest. Contributions to a 401 (k) pension plan demonstrate this perfectly. Suppose you opened a 401 (k) account and deposited $ 19,500 annually (the maximum contribution allowed for 2020 for people under 50) and earned 10% per year. In eight years, you would be making $ 22,000 a year in interest alone.

In other words, the amount you would earn in annual interest would exceed the maximum contribution you could contribute each year.

But compound interest also has a dark side. Debt can accumulate just as efficiently as investments – and if you have high interest rate debt, it can get out of hand quickly as more and more interest accumulates every month.

Wondering how to use compound interest to your best advantage? Here are three ways compound interest can work for you:

  • Interest earned.
  • Time.
  • Dollars invested.

And that can work against you in three ways:

  • Have high interest rate debt.
  • Excess spending within your wallet.
  • Operation of deferred tax accounts.

Compound Interest Can Increase Your Wealth

Interest earned. Where can you earn interest? Bonds, of course. You may also know a certain degree of capitalization in your savings account (generally online banks offer higher interest rates than traditional banks).

Dividends from stocks and distributions from mutual funds are not technically “interest”, but they are a form of income that makes up your portfolio. Basically, any growth in your portfolio provides a greater asset base for compound interest to take effect.

Time. The longer your money is invested (and / or earns interest in a savings account), the more it should benefit from capitalization. Each year your interest in itself increases, that’s more money in your pocket.

The best time to start saving and investing is always now! Don’t be afraid of current market conditions or your thoughts on what might happen with the markets or interest rates in the future.

Design an investment allocation to suit your long-term goals, make sure your cash reserves are maintained at appropriate levels – and get started.

Starting as a saver and investor at a young age also gives you other unique benefits. Having a longer investment timescale means you can afford more risk (e.g. stocks and other higher risk / higher reward assets) because you will have plenty of time to recover from a market downturn. Remember that with higher risk comes a higher potential return (and vice versa).

Dollars invested. It may sound obvious… but money makes money. If the amount you have invested is limited, the benefits of compounding will also be limited. Automate your contributions to savings and investment accounts to put you in a strong position to benefit from compound interest.

Compound interest can reduce your wealth

If you owe money, compound interest means you pay interest on the interest. This is evident when you take out a mortgage for the first time – for a long time your monthly payments are mainly spent on interest and very little on principal repayments.

Have high interest rate debt. Credit cards often carry high interest rates. It can be extremely difficult to come out of a hole when you are constantly being charged interest on interest. Prioritize paying off your highest interest debt first.

Excess spending within your wallet. Excessive investment fees erode your investment returns. To give a very simple real-life example, let’s compare two mutual funds that follow the S&P 500 – their investment methodology is designed to be the same.

One of them is available at a low cost of 0.015% and the other is charged 0.5% per annum. The performance of the low cost fund over the past 10 years was 269.21%, while the performance of the more expensive fund was 252.44%.

Wouldn’t you prefer to have an additional 16.77% in your portfolio? As your portfolio grows, the more expensive fund will eat away at your returns faster.

Tap into your tax-deferred accounts. When you make an early withdrawal from your tax-deferred accounts, not only are you paying a 10% penalty, but you are also forfeiting the ability of those dollars to accumulate over time. It really adds up!

The same goes for a 401 (k) loan, to a lesser extent. It’s not as devastating because the interest you pay is on your own, but you don’t get the growth in your investment during the time your money is out of the plan.

If that withdrawal comes from an individual retirement account, it’s a double whammy. You reduce the dollars left in your wallet available to earn interest, and you also pay tax. One of the biggest advantages of a traditional IRA is the tax deferral interest (keeping the dollars growing and compounding in your pocket for as long as possible, and delaying Uncle Sam’s payment).

As you can see, the power of composition can have a significant impact. You can make a huge difference in your long-term financial success by taking advantage of compound interest and limiting compound interest payments.


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