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Your Financial Life
By Transamerica / Dec 9, 2015

How Compound Interest Can Help Me in 2016

blog-compoundinterest101

As the holiday season progresses, and the new year begins its approach, it can be beneficial to consider your finances and how they can improve for 2016. One source of improvement can come in the way of compound interest.

With Interest 101: What is Interest? we discussed interest and how it can both help and hurt your finances. Well, if you’re a saver or someone who would like to save more, compound interest can benefit you. In fact, when your investments reach the point where their interest is compounding, you’re in a much better financial position.

Einstein hyped it and Franklin proved it.

If you’re a historian, you might be aware of how Benjamin Franklin and Albert Einstein regarded compound interest. Einstein touted compound interest as the “eighth wonder of the world” while Benjamin Franklin actually demonstrated the financial advantages of compound interest.

Upon Franklin’s death in 1790, he left £2,000 British sterling pounds, which would be approximately $50,000 in today’s US dollars, to be split between the cities of Boston and Philadelphia, with the stipulation that both cities establish a fund that would last at least 200 years, but with no provision for withdrawals during the first 100 years. 100 years later, both Boston and Philadelphia were able to take $500,000 out of their 200-year funds, and still have healthy sums left over for the following 100 years. In short, Benjamin Franklin’s objective was to demonstrate the financial benefits of compound interest. His point was made—in 1990, 200 years after his death, the established funds were worth $6.5 million.

What is compound interest?

Think of compound interest as interest on top of interest. When an investment builds compound interest, it grows faster than if it was earning only simple interest. Simple interest is interest that is applied to the principal of an investment or loan. When interest compounds, the simple interest itself begins to earn interest of its own.

At what point do investments achieve compound interest?

An investment needs a history of accruing interest to benefit from compound interest. For example, if you were to take $10,000 and invest it at 6% for one year, at the end of those 12 months, you will have netted $600 for a total of $10,600 ($10,000 x 1.06). Now, if you leave the $600 in your account for a second year, and your interest rate remains 6%, your investment will have grown to $11,236 (10,600 x 1.06).

If you’ll notice, your investment picked up an extra $36 on top of the same $600 profit your $10,000 made in its first year. In the second year, the initial $600 in interest is added to your principal, which in the next 12-month cycle, will itself increase at the same rate if your interest stays at 6%. Continue this type of investing for five years at 6%, and your asset will have grown to $13,382, with a substantial portion of that growth due to the compounding of interest, which began with your initial $36 profit. Notice also that the longer your investment stays untouched, the faster it will grow year-by-year because of its compounded interest.

Do I need a lot of investments to benefit from compound interest?

No, you don’t. A single investment can potentially collect compound interest as easily as several profit-making vehicles. To benefit from compound interest, however, your investment needs to have a history or periods in which it previously collected interest on its principal. So whether you’re a one-asset investor, or have multiple financial properties, compound interest works the same way for all investors.

Some popular investments that can accrue compound interest are:

  • Checking and savings accounts, provided by banks, credit unions and other financial institutions.
  • Zero-coupon bonds, which when purchased at a discount, can accumulate compound interest over the life of the bond, then pay out at face value when the bond is redeemed.

When can compound interest work against me?

Compound interest can work against you through credit card and loan debt. For example, if you borrow $100 from a loan institution at 10% compounded monthly, your debt for the month will be $110. This is because that 10%, which is $10, is added to the loan’s principal, which is $100 ($100 x 1.10 = $110). Now, if you don’t pay off that debt at the end of the first month, that $110 is once again multiplied by 10% for the second month, raising your debt to $121. The types of debt which compound include:

  • Credit cards
  • Bank loans
  • Consumer loans
  • Student loans.

The way around being stuck with compound interest on top of your debt is to simply curtail your use of credit, while also paying more than the minimum balance due on your loans.

How can I earn compound interest from investments?

The same principles apply with compound interest as with any successful investment.

  • Start early, so that you give yourself the greatest opportunity to build a strong investment.
  • Be patient as you allow your investment to grow. While compound interest can quicken the pace of an increase in value, time is still required to give that investment the best opportunity to mature into a substantial value.

Keep in mind that cashing out your interest (or redeeming your investments) can come with additional tax consequences, depending on the investment and the time frame involved. For further information, consult a tax advisor.

When your investments accrue compound interest, they are increasing without any additional expenditure on your part. To achieve this, you first need to find an investment that can garner a reasonable interest rate, and then be patient as that investment grows. Franklin understood it, and Einstein applauded it. As the holidays approach, now might be a good time for you to realize the beauty of compound interest. After all, if not a true eighth wonder of the world as Einstein claimed, compound interest should at least be deemed a wonder of the financial world.

This information is general and should not be considered as investment advice. Each individual’s situation is unique, and you should consider your risk tolerance, personal circumstances, and complete financial situation.

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