Pros and Cons of CompFounding
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Compounding has been referred to as the eighth wonder of the world or man’s greatest invention by Albert Einstein, but the miracle of compounding can also backfire for consumers with extremely high-interest loans, such as credit card debt, which bear very high interest rates. A credit card balance of $20,000 carried at an interest rate of 20% compounded monthly would result in a total compound interest of $4,388 over one year or about $365 per month.
As a positive side, compounding can work in your favor when it comes to investing and can be a powerful factor in establishing wealth. Compounding interest also contributes to mitigating wealth erosion factors, such as increasing living costs, inflation, and diminished purchasing power, through exponential growth.
When an investor opts to reinvest dividends from a mutual fund, he or she will be able to buy more shares of the fund. Investors can benefit from compound interest by investing in mutual funds. Investing in the fund will continue to grow in value as more compound interest accumulates over time.
An initial investment of $5,000 and an annual addition of $2,400 opens a mutual fund investment with a future value of $798,500. The difference between the cash contributed and the investment’s actual future value is called compound interest. With an average annual return of 12% over 30 years, the fund’s future value is $798,500. Using this example, compound interest will add $721,500 to the future balance by contributing $77,000, or $200 per month.
Earnings from compound interest are usually taxable, unless they are in a tax-sheltered account. They are usually taxed at the standard rate associated with your tax bracket, so your balance can fall if the portfolio’s investments lose value.
Investing in compound interest
Dividend reinvestment plans (DRIPs) within brokerage accounts use the power of compounding to help investors grow their investments over time.
Bonds with a zero-coupon offer investors compounded interest as well. Bond issues provide investors with periodic interest payments based on the original terms of the bond issue, and since the interest is paid out as a check to the investor, the interest does not compound over time.
It is not possible to receive interest checks from zero-coupon bonds. Rather, zero-coupon bonds are purchased at a discount and grow over time. By using the power of compounding, zero-coupon bond issuers are able to maximize the bond’s value at maturity.
When you repay a loan, compounding can be beneficial. For instance, paying half your mortgage twice a month rather than making the full payment once a month will result in a shorter amortization period and a significant savings.
Calculate compound interest with these tools
There are helpful tools to help you figure out compounding, even if you haven’t used a calculator for a long time.
How to calculate compound interest in Excel
The following three methods are available in Microsoft Excel if you need to perform more complicated compounding tasks:
- Compound interest is calculated by multiplying the new balance by the annual interest rate. If you deposit $1,000 in a savings account with a 5% compound rate, you will have to multiply it by the annual interest rate to determine your balance. Enter “Year” in cell A1 and “Balance” into cell B1 in Microsoft Excel. In cells A2 through A7, enter years 0 through 5. Assume your year 0 balance is $1,000, and you would enter “1000” in cell B2. Finally, enter “=B2 *1.05” into cell B3. Then enter “=B3*1.05” into cell B4 and continue to do this until you get to cell B7. In cell B7, the calculation is “=B6*1.05”. At the end of five years, the calculated balance in cell B7 is $1,276.28. Subtract $1,000 from $1,276.28 to find the compound interest amount, $276.28.
- Using a fixed formula to calculate compound interest is the second way. P is the principal, i is the interest rate, and n is the number of periods in which it occurs. The same information is used to enter “Principal value” in cell A1 and “1000” in cell B1. Next, enter “Interest rate” and “.05” in cell B2. Next, in cell A3 enter “Compound period” and in cell B3 enter “5”. Now you can calculate the compound interest in cell B4 by entering “=(B1*(1+B2)^B3)-B1”, which gives you $276.28.
- In order to calculate compound interest, you can create a macro function. The Visual Basic Editor can be found in the developer tab. From the Insert menu, select “Module.” In the first line, type “Function Compound_Interest (P As Double, I As Double, N As Double) As Double.”On the second line, hit the tab key and type in “Compound_Interest = (P*(1+i)^n) – P.” On the third line, enter “End Function.” Your function macro will calculate compound interest rates. From the same Excel worksheet above, enter “Compound interest” in cell A6 and “=Compound_Interest(B1, B2, B3).” The result is $276.28, which is consistent with the other two values.
Calculators that calculate compound interest
There are a number of free compound interest calculators available online, and many handheld calculators can also calculate compound interest:
- Using Financial-Calculators.com’s free compound interest calculator, you can choose between daily and yearly compounding frequencies. A continuous compounding option is available, along with the option of inserting actual calendar start and end dates. After entering the necessary calculation data, the results show interest earned, future value, annual percentage yield (APY) (a measure including compounding), and daily interest.
- A free online compound interest calculator is available at Investor.gov, the Securities and Exchange Commission’s website. In addition to being relatively simple, it also allows you to input monthly additional deposits to the principal, allowing you to calculate earnings when you add additional monthly savings.
- You can find a free online interest calculator at TheCalculatorSite.com with a few more features. Calculation options include calculating for different currencies, factoring in monthly deposits and withdrawals, and automatically calculating inflation-adjusted increases to monthly deposits and withdrawals.
What Does Compounded Interest Mean?
A lender must disclose to prospective borrowers loan terms, such as the total amount of interest to be repaid over the loan’s life and whether interest accumulates simply or compounded, under the Truth in Lending Act (TILA).
An alternative method is to compare a loan’s interest rate with its annual percentage rate (APR), which the TILA also requires lenders to disclose. In other words, the APR converts all interest and fees associated with your loan into a simple interest rate. It is likely that your loan uses compound interest or it includes heavy loan fees in addition to interest if your interest rate and APR differ substantially. Depending on the financial institution’s fees and other costs, the APR range can vary wildly even for the same type of loan.
As you might expect, the interest rates charged to borrowers with excellent credit are significantly lower than those charged to those with poor credit.
How Do You Define Compound Interest?
The key word here is compound. Compound interest is nothing more than interest that increases exponentially over time rather than linearly.
When you invest $100 in a business and it pays you a 10% dividend every year, you can either pocket the dividends or reinvest them in additional shares of the business. Over time, you will be able to grow the returns you generate by reinvesting the dividends and compounding them together with your initial $100 investment if you choose the second option.
What are the benefits of compound interest?
Investors benefit from compound interest when they lend money and reinvest the interest they receive in making more loans. Lending money to banks and reinvesting interest earned benefits them from compound interest. Interest on bank accounts, bonds, and other investments can also benefit depositors from compound interest.
Even though compound interest includes the word interest, the concept applies to more than just bank accounts and loans, for which interest is typically used.
What are the benefits of compound interest?
There are records of merchants, lenders, and various business people using compound interest to become wealthy for literally thousands of years. Compound interest is one of the strongest forces for generating wealth. A clay tablet was used in Babylon over 4,000 years ago to teach students about compound interest.8
By diligently compounding his investment returns over long periods of time, Warren Buffett became one of the world’s richest people in modern times. For the foreseeable future, compound interest will likely be used to generate wealth in some form or another by people.
Conclusion
Compound interest has a miraculous effect on savings and investments over the long run. It is a central factor in increasing wealth because it grows your money much faster than simple interest. It also mitigates the effect of inflation on living costs, as it will almost certainly outpace them.
A compound interest rate is especially useful for young people because they have so much time to save up. Keep in mind that the number of compounding periods you choose is just as important as the interest rate when choosing your investments. Is there anyone who wouldn’t want to turn $48,000 into $1.17 million, even if it takes 40 years?
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