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How Compound Interest Makes You Money Thumbnail

How Compound Interest Makes You Money

Interest is one of the simplest and most appealing ways to gain profits from an investment. Like clockwork, you receive an interest payment on your principal, or the amount of money you deposit when you open an account.

Unlike more turbulent investments such as stocks, whose revenue is dependent on your ability to sell at a profit, accounts that pay interest will always generate some amount of profit—with only some rare exceptions.

However, there is more than one type of interest, and not all are created equal. One of the more profitable, and complex, varieties is compound interest. Let’s break down how this revenue generation system works and detail finding an account that incorporates its reliable, lucrative dividends.

Interest at work

First, it’s important to understand how simple interest works. In this basic system, you earn interest only on the principal. Say that you invest $1,000 in a savings account at a bank. If this account pays 5 percent interest as an annual percentage yield, then you’ll earn $50 every year. This means that at the end of three years, you will gain $150 in interest profits for a total account balance of $1,150. As long as you have such an account that pays simple interest, you will always earn this flat interest rate of $50 a year.

Compound interest, on the other hand, grows at a variable rate rather than a fixed one. Think of it as gaining interest on interest. Following the previous example, if you open an account with $1,000 at 5 percent compounding interest, you will still earn the same $50 dividends at the end of the first year. However, the second year, the interest will be calculated from your new account balance of $1050—the principal plus interest. The second year’s interest will be $52.50, then $55.13 the next. By the end of year three, your new account balance will be $1,157.63.

That’s a difference of $7.63 compared to simple interest account dividends. Though this amount may seem small, bear in mind that compound interest becomes more profitable with a larger principal and longer investment period. In other words, the more your balance grows, the more rapidly it grows. So if you invest $10,000 for ten years at a 5 percent rate of return, you will profit $6,288.95 in compound interest alone.

Perhaps the best way to learn how this investment revenue works is to see it in action. If you’re considering depositing finances in an account that gains compound interest, visit this convenient online calculator from Investor.gov to help you project the earnings from your initial investment, plus any ongoing contributions, over a set period of time.

Interesting calculations

As you can imagine, compound interest isn’t always as simple as the above example indicates. Many factors can affect how your interest compounds, the first of which is making changes to your principal investment. If you add or withdraw funds from your account (which certain investment types allow for) you change the rate the interest accumulates at. The more money you take out, the smaller your interest profits will be—and vice versa. This is one reason why financial advisors highly recommend that everyone invest at least a small amount of money into a savings account every month.

Additionally, various account types may compound at different rates. For example, some savings accounts pay interest monthly, which pays you more interest per year. Your interest rate may also change over time, which will have ensuing effects on how your balance continues to grow. To best anticipate your potential earnings, get all of this information in detail from an account representative before you make a principal investment.

Which accounts pay compound interest?

This interest type is actually extremely common. Investments that may provide a compound rate of return include:

  • Savings accounts: Store money in a bank or credit union securely while earning a relatively low but surefire interest rate.
  • Checking accounts: Designed for everyday use, including depositing, making payments, and accessing cash, these accounts may pay interest, although this is rare.
  • Money market accounts: Deposit funds at a financial institution at an attractive interest rate. These accounts may generate more revenue than standard savings accounts but often have stricter guidelines like a higher minimum deposit and limited withdrawals.
  • Certificates of deposit: These higher-yield savings accounts involve loaning your funds to an institution like a bank for a predetermined period of time. In most cases, you cannot withdraw money before the term ends without paying a fee.
  • Cash management: Rather than banks, these accounts are available from service providers like financial advisors and brokers and bundle the features of multiple investment types. However, unlike savings accounts, cash management investments may be uninsured.

A wise financial strategy

Although there are investments that may be more lucrative, such as real estate or stock index fund holdings, depositing funds in an account that pays compound interest carries less risk and economy-sensitive volatility. This means that even if a system like a money market account doesn’t generate the highest yield, it is essentially guaranteed to offer some form of profit, all while protecting your principal investment and requiring little to no work from you. With an account that pays compound interest, you get to sit back and watch as your money grows over the years, generating modest yet reliable profits.


Important Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. 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.

CD’s are FDIC Insured and offer a fixed rate of return if held to maturity.

This article was prepared by ReminderMedia.

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