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Money Management Center

The Pros and Cons of Compound Interest

Shauna O'Brien Oct 15, 2014


Interest rates are on the minds of most consumers. Whether it is the interest rate on loans or the yields on various investments, almost everyone has some sort of stake when it comes to interest. Moreover, the accumulation of interest is a big concern among those with debts and investments. Sometimes this interest can be beneficial to your wealth, while other times interest can end up draining your bank account. Depending how you take advantage of certain interest rate calculations, it can truly benefit your overall wealth while limiting downsides.


Calculating Interest


There are primarily two ways to calculate interest for most consumers. First there is simple interest. This only calculates interest by multiplying the rate by the principal of a loan, debt or investment; it never adds the unpaid interest accumulated to the principal to calculate total returns. In regards to investments, the returns to many fixed income vehicles like bonds and dividend price appreciation are calculated with simple interest. Calculating interest this way would be great for those with loans as it would keep total payment down, but bad for those with investments who would like to see big, exponential returns.


Compound interest, on the other hand, is a different beast. This interest is computed on the accumulated unpaid interest as well as the original principal. Certain investments, like savings accounts, certificates of deposit and reinvested dividend stocks, utilize the benefits of compounding interest. This interest calculation benefits you in the opposite way of simple interest; it is great for investments, but horrible when it comes to loans.

For the most part, compound interest is what most of us deal with in our savings, investments and loans. Having some sort of understanding of the nuances of compound interest can truly help in building long-term wealth.


A Brief History of Compound Interest


Compound interest has been a controversial topic throughout history. Both Christian and Islamic texts have condemned the practice of compound interest by creditors, describing it as a sin. Also, in Roman law compound, interest on loans was illegal, as well as denounced in other ancient cultures. But as we all know, compound interest outlasted this initial resistance and became a substantial force in finance.

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t… pays it.” Though disputed, this quote is widely attributed to the brilliant Albert Einstein. People like to believe that if a man of such prominence and intelligence believes compound interest is so great, then maybe it is necessary. Regardless of who actually said these words, it should not take away from its meaning. Compound interest can be your best friend, or your worst enemy.


When Compound Interest Is Your Friend


In investing, compound interest, with a large initial principal and a lot of time to build, can lead to a great amount of wealth down the line. It is especially beneficial if there are more periods of compounding (monthly or quarterly rather than annually). This allows for a potentially exponential build up of total returns. You’re earning money from the interest you’ve already earned.

For example, if you were to invest $10,000 into a 30-year investment vehicle with a 5% annual compounded interest rate, then at maturity you would have $43,219.42 ($10,000 principal plus $33,219.42 in interest). Conversely, if a simple interest calculation was used, that same investment would result in only $25,000 ($10,000 principal plus $15,000). As the principal, interest rate, and compound periods increase, so does the future value of an investment.

It doesn’t matter if you are just putting some money into short-term, low rate savings accounts or CDs or long-term, higher return investments, compound interest will work for your benefit if you allow it.


Dividend Investing and Compound Interest


Dividend investing, if done properly, can share many of the same benefits that compounding interest offers in certain investments. When you reinvest dividends back into the market, purchasing more shares with dividends earned, over time that wealth exponentially increases. Over the long-term you will earn more than if you were to just take dividend income and put it in your pockets.

For example, if you were to invest $10,000 in a dividend stock that had an average annual return of 12% (a total of stock price appreciation plus dividend yield) and you reinvested the dividends; in 30 years that investment would result in $299,599.22. However, if you invested $10,000 in a non-dividend paying stock with the same annual return over the same amount of time, your total return would only be $132,676. That’s a substantial $166,923 difference. That sure shows the potential power of dividend investing and compound interest theory.


An investor can take advantage of reinvesting in one of two ways. For one, you can utilize dividend reinvestment plans that are offered by certain companies and brokerages. If neither a company nor brokerage offers a DRIP for a stock, then you can just take the dividends paid out to you and reinvest them yourself, possibly with additional funds that could bolster overall returns. Regardless, there are a number of ways to take advantage of compounding interest when it comes to dividend investing.

You can utilize Dividend.com’s Compounding Returns Calculator to see how an investment can grow over time.


When Compound Interest Is Your Enemy


When it comes to loans, we all know the interest that builds on an initial principal can be hard to stomach. The primary reason for an increase in overall payment of a loan is due to the compounding interest. This is because when you incur debt, you pay interest until the total loan plus interest is repaid. As time goes on, more interest is compounded to the original loan plus the previous interest added. It can be a vicious cycle. So if you only pay a monthly minimum on a credit card bill, the total bill can end up increasing substantially where you either end up paying a large amount more than the original purchase or the debt becomes insurmountable.

You can combat the negative effects of compound interest on loans by paying a little bit more than the minimum each month. For small loans like credit card bills, it is ideal to pay off the total as soon as possible. However, for large debts like a mortgage or car loan, by paying just a little more than the minimum each month it can end up leading to a surprising amount of savings, helping to maintain overall wealth. Check out A Common-Sense Guide To Credit Cards to find out how to get your credit card debt in order


The Bottom Line


Compound interest is great when it works in your favor in investments, but it can also be your biggest enemy when it works against you in loans and other debts. The key is to figure out how you can let it work in your favor. If you stay on top of your loan payments and always keep an eye on your investments, then compound interest can be your best friend when it comes to wealth. Having control of your personal finances makes it easier to navigate the road as you look towards the future.

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