Our partner, XM, lets you access a free demo account to apply your knowledge.
No hidden costs, no tricks.
Investing revolves around deploying cash in various asset classes, such as stocks, bonds, real estate, etc. However, the process also often leads to the accrual of residual income in the form of cash. Simply leaving your capital without a function makes it susceptible to inflation, which diminishes its purchasing power and essentially reduces your wealth. To combat this, many investors, regardless of their net worth, tend to use compound interest accounts to safeguard their residual cash assets.
Compound interest accounts compound the general interest applicable to a deposit made in a bank, which leads to an increased annual yield on the principal deposit amount. This can be convenient in a myriad of ways; as not only do compound interest accounts protect capital from inflation, but also add to a decent profit on top.
Compound interest accounts are some of the most popular deposit types made in global banks with a positive annual interest rate, which makes it all the more important for beginner investors to know how compound interest works and how it can help them build wealth in the long run.
If you are one of such prospective investors - this investfox guide on compound interest is for you.
Compound interest accounts are financial accounts offered by banks or other financial institutions that allow you to earn interest on your initial deposit as well as on the accumulated interest over time.
Key features of compound interest accounts include:
Compound interests work to accumulate interest on the principal, as well as the interest paid on the principal, which means that with each new payment, the principal changes and includes the accrued interest up to the next date.
Compound interest accounts have an edge over traditional deposit accounts, as their annual percentage rate tends to be higher.
Compound interest accounts operate using a simple compounding formula that is easy to calculate and involves the initial principal amount, interest rate, the number of times interest was applied per period, and the number of periods:
A = P(1+R/N)^NT
A = final amount
P = principal amount
R = interest rate
N = number of times interest is applied per time period
NT = number of time periods
Manually calculating compound interest is not necessary, as deposit accounts will indicate the expected APR when opening the account.
The compounding formula is useful for other types of investments as well, considering all profits are reinvested into an investment with a fixed annual interest rate.
The typical bank deposit may offer an annual simple interest that is paid annually or in regular intervals, however, the annual yield does not exceed the terms agreed upon in the contract.
For example, a simple interest account with an annual interest rate of 5% on a $10,000 principal would return $500 per year.
Let’s assume that an investor is considering putting their spare cash in an interest-bearing account for 5 years with an annual interest rate of 5%. In the case of a simple interest account, they would have earned $2,500 in interest by year 5.
Conversely, a compound interest account would have netted $2,762.8.
While the difference may not seem so big at first, we must keep in mind that the effect of compounding interest goes into full effect after longer time frames.
For instance, the same scenario over a 10-year period would yield the following returns:
Simple interest account - $5,000 by year 10
Compound interest account - $6,288.9 by year 10
The difference in this case is more than $1,288.9, which is an almost 13% difference in annual yield for the principal amount. The larger the time frame and annual interest rate - the more evident the effects of compounding become.
Building long-term wealth through compound interest can be tricky and involves some careful considerations, such as the annual rate of inflation and the probability of interest rate fluctuations.
For example, during a regular year in the United States, the annual targeted rate of inflation is 2%, which means that any return above 2% would be netting a profit by the end of the year.
Suppose an investor has $100,000 to spare and would like to invest in a basket of bonds with an average annual yield of 4% per year. If the investor holds it for 20 years, their returns would reach $219,112, which equals total returns in excess of 119% over the period.
Now, while it is true that there are investments that can yield considerably more than 119% over 20 years, compound interest is geared toward cautious investors who wish to put their spare capital to work.
Placing a portion of investment gains in compound interest accounts can be a great way of creating a safety net over the long haul - especially if interest rates are high.
While the compounding periods offered by different financial institutions can vary greatly, certain types of instruments and financial accounts offer a comparable compounding period.
The compounding period depends on the type of investment and annual yield, as well as financial regulations upheld by relevant bodies to ensure the security and stability of the financial system.
Furthermore, each financial instrument is geared for a specific time frame in mind, and longer investments that are typically less liquid are likely to compound on a quarterly, semiannual, or annual basis, while standard bank deposits compound daily.
Some common interest compounding periods include:
Choosing the right instruments is crucial in getting the most out of compounding and certain instruments can be subject to tax deductions and other benefits, which can lessen the overall tax burden for the year.
Choosing the right compound interest account is important for maximizing the annual yield of your account. Banks may offer additional services that can make your investment experience more convenient.
Some important factors to consider when choosing the financial institution to open a compound interest account with include:
Assessing the aforementioned factors can help you choose the best compound interest account for your investment needs to keep your cash secure and growing in the long run.
Before picking a specific compound interest account with a bank or other financial institution, it is important to carefully consider the inherent advantages and disadvantages associated with keeping your capital in a compound interest account to assess whether this is the right course of action for your objectives.
Compound interest accounts can be a great way for investors to put their spare cash to work. Compound interest is generally beneficial, especially for long-term investments. However, it's important to consider the interest rate, inflation, taxes, and investment duration.
Compound interest accounts accrue interest on the principal amount as well as the interest. Each interest-bearing installment assumes the principal amount alongside the already accrued interest on that principal.
Simple interest is calculated solely on the initial principal amount, whereas compound interest takes into account both the principal and any previously earned interest. As a result, compound interest generates higher returns over time compared to simple interest.