A lot of people wonder if they can become millionaires through compound interest. This will not make you a millionaire overnight, but it is much better than simple interest.
There is one more concept that you need to know about that is even better than compound interest. All we have to do is add “uninterrupted” in front of it.
Let’s explore these concepts and show how you can benefit from uninterrupted compound interest.
What is a Compound Interest?
First of all, compound interest is the interest you earn on interest. Sounds confusing? Let’s explain it.
The term “interest on interest” originated in 17th-century Italy.
Compound interest is the interest on a loan or deposit calculated based on the initial principal and the accumulated interest from previous periods.
In other words, it’s interest on top of interest.
Each period (usually a year), the interest accumulated in the previous period is added to the principal, and then the next period’s interest is calculated on the new, higher principal.
This creates a “snowball effect,” where the interest earned in later periods is larger than in earlier periods.
It is a much better solution to simple interest, but let’s compare compound and simple interest to understand both of them:
Simple vs. Compound Interest
Simple interest is the interest rate multiplied by the investment or principal amount.
Simple and compound interest are both used for specific purposes:
- Simple interest is more commonly used in loans where the interest is the same every period, and there is no event of compounding.
- Compound interest is used in the contexts of investment and savings.
Simple Interest Formula
This means that the account value equals the principal investment amount multiplied by one plus the rate multiplied by time.
Because it does not include the compounding factor, the simple interest formula is less complicated than the compound interest formula.
The Compound Interest Formula
The account value, also known as a future value, is calculated using the following compound interest formula:
A = P(1 + R/N)^(NT)
- The letter P denotes the investment or principal balance at the commencement of the asset. When calculating interest with a compound interest calculator, the principal is also known as the present value.
- The letter R denotes the interest rates earned on the investment.
- The number N characterizes the number of times interest is compounded per period. For instance, many high-yield savings accounts compound monthly but have an annual rate.
- The number of time periods is indicated by the letter T.
The best examples are self-explanatory, so imagine you invest $20,000 with a 2% rate of return compounding monthly. After two years, your account balance would be:
A = 20,000(1 + 0.02/12)^(12*2)=$20,815.52
How Does Compound Interest Work?
Now that you know what compound interest is and how to calculate it, let’s see how it works. When you invest, you earn interest on your money, either monthly or annually.
Usually, when we talk about savings accounts and interest payments, they accumulate annually. Since the first year, there has been an increase in interest.
In the second year, you start earning interest on the original investment and on the interest from the previous year. In the third year, you earn interest on your initial investment and from the last two years.
Each time, you not only gain more, but you also earn a higher return. You can see now why compound interest is popular across the board.
This is one of the best methods for saving money for a retirement account, making more significant purchases, or raising capital for a small business. Even if you’re trying to live below your means and save some money, you can still use the power of compound interest to speed up the process and earn more as time passes.
What is Uninterrupted Compound Interest?
Uninterrupted compound interest refers to interest that is continuously compounded over a period of time without any breaks or interruptions. This means that the interest earned on a principal sum is added to the principal, and the new total is used to calculate interest in the next period.
This process is repeated for as long as the investment is held, which causes the principal to grow at a very fast rate.
On the other hand, compound interest refers to interest that is compounded at fixed intervals, such as annually or semi-annually. This means that the interest earned on a principal sum is added to the principal after a specific period of time, and the new total is used to calculate interest in the next period.
As a result, uninterrupted compound interest will generate higher interest than compound interest over a given period.
Uninterrupted Compound Interest and Compound Interest Example
For example, if you invest $1000 at an annual interest rate of 5% with uninterrupted compound interest, after one year, the interest earned would be $50, bringing the total to $1050. In the next year, the interest earned would be $52.5 (5% of $1050), and so on.
If the same investment were compounded annually, the interest earned in the first year would be $50, but it would be added to the principal only at the end of that year. So the principal amount remains at $1000 for a year, and after that, it will be $1050, and interest is calculated on that principle.
Compound interest can only be maximized if you stay invested and keep it uninterrupted.
If you keep transferring or withdrawing money from your compound interest accounts every time the market goes down and don’t keep adding money to the account, you’ll miss out on a lot of possible earnings.
Check out one more example in the image below:
The Power of “Uninterrupted”
The compounding power requires time for the magic to work. Most financial advisors recommend investing in the stock market or in bonds. Mutual funds and managed accounts are the most popular investment vehicles.
As you already know, investing involves risk, and you can lose money instead of gaining it. And the past performance doesn’t necessarily reflect your future results.
Most investors strive to keep up with market indexes such as Canada’s S&P/TSX Composite index and the S&P 500 index. This is primarily because other financial services, such as GICs and high-yield savings accounts, provide 1-2 percent returns.
With inflation at 2% and taxes on gains, you almost have a negative return. Over long periods of time, the previously mentioned market indexes have averaged 7-9 percent.
If you’ve had the good fortune to time your deposits correctly and the discipline to keep your money invested for decades, you’ve seen these returns before. But before you think you’ve done well, remember that we have to account for management fees and taxes.
The fees are known as the MER (Management Expense Ratio). These fees, which range between 2 and 2.5 percent, are deducted from your returns.
This can add up to thousands of dollars over the course of 30 years, which could have been left to compound indefinitely. Rather than chasing a high ROR, it is better to have a long-term mindset and invest your money in a place where it can grow without investment losses, taxes, or hidden fees.
4 Key Points to Calculating Compound Interest
There are four key factors when calculating compound interest. Each one plays a unique role in the capital gains, and some variables can have a significant impact on your returns.
- The initial investment – The amount of money you initially deposit in your bank account or how big of a loan you took out has an impact on how your balance will be able to generate earnings. While compounding accumulates over time, it is all based on the initial amount you deposit or borrow.
- Interest – This is the rate of interest you earn or is charged. The higher the interest rate, the more money you earn or owe.
- Compounding frequency – The rate at which interest is compounded: daily, monthly, or annually —determines how quickly more interest is gained. Ensure you understand how often interest compounds when you take out a loan or open a savings account.
- Duration – The longer you leave money in a savings account or keep a debt, the longer it has to compound and the more you’ll earn or owe withdrawals and deposits. The rate at which you accumulate principal or pay down your loan makes a significant difference in the long run.
5 Benefits of Compounding Interest
Obviously, you can benefit greatly from uninterrupted compounding, and the sooner you start investing and learning about this principle, the better.
Consumers can use compound interest in cash accounts, savings accounts, or other forms of accounts to grow small savings into beneficial retirement accounts or capital for their small businesses over time.
Let’s explore all the benefits:
- Faster growth of investment or savings – By explaining the concept and giving a hypothetical example of investing $1000, you can assume this benefit. Compounding interest allows an investment or savings to grow faster than if only simple interest were applied, as interest earned is added to the principal, resulting in exponential growth over time.
- Earning on earnings – You can earn additional money on your earnings, which is great if you have a mutual fund or start investing in the stock market. The compound interest works to your advantage naturally, which is why many people look to capitalize on it.
- Time value of money – Money today is worth more than the same amount of money in the future. When you apply compound interest and invest early, your money will not use value, which it does if you just start saving without making any investment decisions. Leaving the money to sit in your nest egg isn’t necessarily bad, but if it stays there for too long, the value of money decreases as inflation goes up.
- Long-term wealth-building – Compounding interest is an effective strategy for building wealth over the long term, especially when combined with consistent investment and a long time horizon. Furthermore, later in the article, we will show you how you can use this in combination with life insurance policies and lifestyle ownership.
- You can leverage it with consistent investments – For example, by investing in a 401k over the course of a career, with the employer match and consistent contributions, the power of compounding can compound the investments over many years.
5 Downsides of Compounding Interest
While compounding interest benefits both financial institutions and people who have many savings accounts and compound interest accounts, there are some downsides that we need to mention:
- It can be hard to understand – The concept isn’t easy to understand. We did our best to explain it here, but once you start investing and applying compound interest in real life, it is where many people give up. The deposited money accumulates, but withdrawing funds can break the cycle. Staying invested and keeping track of your financial situation is key.
- Requires patience – The benefits of compounding interest are not realized immediately, and it often takes a long time for the full effects to be seen. This can be a drawback for people who want to see quick returns on their investments.
- Requires consistent investments – In order to leverage the power of compounding interest fully, consistent investments must be made over a long period of time. This can be a disadvantage for those who don’t have the discipline to invest consistently or cannot make a sound investment decision due to the lack of knowledge or capital.
- Compounding can be affected by market fluctuations – The performance of an investment, especially over the long term, can be affected by market fluctuations which can change the originally planned growth expectation.
- It can be costly – One disadvantage of compound interest options is that they can sometimes be more expensive than you realize. The cost of financial products is not always obvious, and if you do not carefully manage your investment, making interest payments can cost you money.
Accounts With Compound Interest
Let’s see which accounts use compound interest:
When you make a deposit into an interest-earning account at a bank, such as a typical savings account or cash account, the interest is deposited into your savings account and added to your balance. This aids in the development of your balance over time.
Earnings in your 401(k) and other investment accounts compound over time as well. The percentage gains that stocks make daily are calculated based on their performance the day before, which means that they compound every business day. Additionally, there is no required minimum distribution.
You can have your penny doubled even faster if you reinvest your dividends and make regular deposits.
Money Market Accounts
Money market accounts are similar to savings accounts in most ways, but money market accounts allow you to write checks and make ATM withdrawals. Money market accounts typically offer a slightly higher interest rate than savings accounts.
The disadvantages of money market accounts are that most have monthly transaction limits and sometimes charge a fee if your balance falls below a certain amount.
When you borrow, compound interest works against you. You must pay interest on any money you do not repay when you borrow money.
If you fail to cover your charges within the time period specified in your loan, they are capitalized or added to your initial loan balance. The future interest rate is calculated on the new, larger loan balance.
Dividend-paying stocks generate compound interest if dividends are reinvested. You can instruct your brokerage firm to reinvest all dividend payments and purchase additional shares automatically through your dividend stock account.
Your credit card company charges interest on the balance on your card every month. Your balance will remain the same if you never charge anything else to the card and pay the accrued interest each month.
However, if you do not pay enough to cover the new interest for the month, it will be added to your credit card balance. The following month’s interest is calculated using the higher amount.
This can cause your balance to snowball over time and take you closer to earning a million dollars. It is important to check your account regularly and keep track of what’s going on.
Create Infinite Savings Accounts For Guaranteed Compound Interest
This is what we love to call a savings account on steroids—an account that will allow you to use your money, invest it, and create generational wealth through compounding and some other strategies as well.
To start, you will need a life insurance policy—not just any—a whole life insurance policy. This particular insurance comes with a cash value component, which is crucial when you need to borrow money, take loans, or simply grow your wealth.
The cash value of the life insurance policy will be used as collateral as you take loans from your insurance company. You can repay those loans, but you will also recapture interest rates.
The cash value also acts as a savings account to which compound interest is applied and keeps growing one year after another. Through various investments, you can increase your cash value, create cash flow, and achieve financial freedom over time.
This concept is also known as infinite banking, as it allows you to become your own bank and leverage your policy for infinite opportunities.