Compound interest can significantly affect the future value of some investments. Many investments such as stocks do not pay interest, so the positive affect of compounding does not affect them. You make income on stocks through capital growth, which drives the share price up. However, whether your investments consist of simple bank savings accounts or corporate bonds, compound interest can boost your portfolio's value.
Interest on Interest
Compound interest means you earn interest on interest. However, the benefits of compound interest only apply if you leave your interest in your account and do not spend these earnings. Compound interest can turn a modest original 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 typically less than the current value. Compound interest can reverse the historical devaluation of each dollar. Increasing inflation can drive the future value of money down faster than time alone. Compound interest rarely compensates for the typical decline in the value of dollars in the short-term. However, it can counteract that decline over longer periods.
Pouring your interest earnings into a different investment typically reduces or eliminates the benefits of compound interest. However, depending on the quality of your new investment, it may generate more earnings than compound interest. Bonds and real estate investments often provide interest at regular intervals, allowing you to increase your account or use these earnings to make new investments.
The number of compounding periods in a year and over the life of the investment directly affect the compound interest benefits you receive. The more compounding periods, the stronger the affect on future investment value. The more interest-posting dates, the more compounding increases your account balance, regardless of your interest rate.
The formula for compound interest is "P" multiplied by the following: (1 plus "r") to the power of "n," minus 1. "P" equals principal or original balance, "r" equals the rate of interest each compounding period and "n" is the number of compounding periods. For example, if you open a $1,000 account with monthly compounding at 12 percent interest a year, your calculation is $1,000 multiplied by the following: 1 plus .01 -- which is 12 percent divided by 12 months -- to the 12th power, minus 1. This works out to $1,000 times 0.12683, or $126.83 in the first year -- more than the $120 you would earn without compounding. You can use online financial calculators to estimated the future value of your investments that earn interest.
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