Would you prefer to earn interest -- or pay it? Understanding how compound interest works allows you to make better decisions in your investment portfolio and your overall financial life.
Compound interest is the ability for your money to make interest on the interest. Contributions to a 401(k) retirement plan demonstrate this perfectly. Assume you started a 401(k) account and deposited $19,500 each year (the maximum allowed contribution for 2020 for people younger than 50), and earned 10% per year. In eight years, you would be earning $22,000 per year in interest alone.
In other words, the amount you would earn in annual interest earned would surpass the maximum contribution you could contribute each year.
But compound interest has a dark side, too. Debts can compound just as effectively as investments -- and if you have high interest debt, it can get out of control quickly because more interest is compounding on itself every month.
Wondering how to use compound interest to your best advantage? Here are three ways compound interest can work for you:
-- Interest earned.
-- Dollars invested.
And three ways it can work against you:
-- Having high-interest debt.
-- Excess expenses within your portfolio.
-- Tapping into tax-deferred accounts.
Compound Interest Can Increase Your Wealth
Interest earned. Where can you earn interest? Bonds, of course. You can also experience a degree of compounding in your savings account (usually online banks offer higher interest rates than brick-and-mortar banks).
Dividends from stocks and distributions from mutual funds are not technically "interest," but they are a form of income that compounds in your portfolio. Basically, any growth in your portfolio provides a larger base of assets for compound interest to work its magic.
Time. The longer your money is invested (and/or earning interest in a savings account), the longer it has to benefit from compounding. Each year your interest grows on itself is more money in your pocket.
The best time to start saving and investing is always now! Don't be scared off by current market conditions, or your thoughts about what might happen with markets or interest rates in the future.
Design an investment allocation suitable for your long-term goals, ensure your cash reserves are shored up to appropriate levels -- and get going.
Beginning as a saver and investor at a young age also provides you with other unique advantages. Having a longer investment time scale means you can afford more risk (e.g., stocks and other higher risk/return assets), since you'll have plenty of time to recover from a downturn in the market. Remember that with greater risk comes greater potential return (and vice versa).
Dollars invested. This may seem obvious ... but money makes money. If the amount you have invested is limited, then the benefits of compounding will also be limited. Automate your contributions to savings and investment accounts to put yourself in a strong position to benefit from compound interest.
Compound Interest Can Decrease Your Wealth
If you owe money, compound interest means you pay interest on interest. This is evident when you first take out a mortgage -- for a long time, your monthly payments go mainly to interest and very little toward principal payments.
Having high-interest debt. Credit cards often come with high interest rates. It can be extremely hard to dig out of a hole when you are constantly being charged interest upon interest. Prioritize paying down your highest interest debts first.
Excess expenses within your portfolio. Excessive investment fees erode your investment returns. To provide a very simple real-life example, let's compare two mutual funds that track the S&P 500 -- their investment methodology is designed to be identical.
One of these is available at a low cost of 0.015%, and the other charges 0.5% per year. The performance of the low-cost fund over the past 10 years was 269.21%, while the performance of the more expensive fund was 252.44%.
Wouldn't you rather have an additional 16.77% in your portfolio? As your portfolio grows, the costlier fund will eat away at your returns faster.
Tapping into your tax-deferred accounts. When you take an early withdrawal from your tax-deferred accounts, not only will you pay a 10% penalty, but you're also giving up the ability of those dollars to compound over time. This really adds up!
The same is true of a 401(k) loan, to a lesser extent. It's not quite as devastating because the interest you pay is to yourself, but you aren't benefiting from investment growth during the time your money is out of the plan.
If this withdrawal is from an individual retirement account, it is a double whammy. You reduce the dollars remaining in your portfolio available to earn interest, and you also pay tax. One of the biggest advantages of a traditional IRA is the tax-deferred interest (keeping the dollars to grow and compound in your pocket as long as possible, and delaying having to pay Uncle Sam).
As you can see, the power of compounding can have a significant impact. You can make a massive difference to your long-term financial success by taking advantage of earning compound interest and limiting paying compound interest.
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