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How Does Compound Interest Work In Investing?

How Does Compound Interest Work In Investing?

August 03, 2022
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How Does Compound Interest Work In Investing?


Any good investor must possess two essential qualities—the ability to pick a suitable investment and the patience to watch it grow over time. Compound interests are something that plays to these two key strengths. This article will help you understand what compound interest is and how you can invest in compound interest. If you have any further questions, the Financial Advisors at Diddel & Diddel are here to help!

What is Compound Interest?

Compound interest is a form of two-fold interest. Unlike simple interests where the amount on only the original sum increases. In compound interest, the original sum increases to give you the first interest, and then both the original sum and the first interest also increase.


For example, If you invest $1000 with a 50% annual compound interest, you will have $1500 in your first year and $2250 in the second year. You get this figure because the original sum ($1000) and the interest ($500) increase by 50%. 

Compound Interest Examples

An investor with an investment with compound interest will watch his money grow exponentially. Some examples of where compound interest benefits you include:

Savings Accounts and Certificates of Deposit (CD).

These accounts compound your deposit, although they don't have anything as outrageous as 50%. Banks place a compound interest on your deposits to allow them to use your money for a business.

Investment Accounts and (401)K Accounts

Money in 401k and other investment accounts also compound over time. Sometimes, the interests compound daily based on the performance of stocks. 


Other factors influencing the compound interest you gain include how frequently you deposit or if you reinvest your dividends.


Note: Sometimes, compound interest can also work against you. If you take on a loan with compound interest, the interest on the loan also increases in time, causing you to pay so much more.

How Do You Invest in Compound Interest?

Investing in compound interests requires know-how, guts, and patience. Compound interest only yields benefits over a long time. Some investments take at least a decade to mature, and a lot can happen in ten years. You will need to ask the following questions of businesses or companies who offer compound interests:

What is the Rate of Compounding?

Several ventures compound at different intervals. Some compound daily, others compound monthly or annually. A venture that compounds daily or monthly will yield you more cash than those that compounds annually. 

What is the Annual Percentage Yield (APY)?

APY is the amount the company will make you after each year; it includes the money from both capital and compound interest. APY differs from the Annual Percentage Rate (APR), which only covers simple interest. A good APY is a good sign that it would be worth investing money in the venture.

What is the Risk Factor?

Some ventures have a minimal risk factor, so you are less likely to lose money. But they also give low returns on investments.


On the other hand, some investments have higher risks but will yield more returns on dividends. Generally, you should begin investing in low-risk ventures and gradually diversify into higher risk as your expertise improves.


How to Calculate Compound Interests

You can calculate compound interest using the formula:


A = P (1 + r/n) ^nt


P refers to the principal (or original amount invested), r stands for the interest rate, n signifies the number of times the interest compounds per time period, and t is the number of time periods.


Case Study


Suppose you invest $5000 at an annual compound interest rate of 5%, and you need to find out how much you will gain after ten years. Assuming the interest compounds monthly, you can calculate your profit by writing:


P= 5000, r = 5/100 (0.05), n = 12, t= 12.


Then, A = 5000 (1 + 0.05/12)^ (10 X 12) = 8235.05


So an investment of $5000 will yield you $8235.05 in ten years. If you don't relish the hassle of making this calculation, you can use this compound interest calculator. Diddel & Diddel Compound Interest Calculator 

What Investments Pay Compound Interests?

Investing in ventures with compounded interests is a good way of making passive income. You may be interested in the following ventures:

A Diddel & Diddel wealth management and growth strategy implements compound interest. Contact us to learn more about it!

Certificates of Deposits (CDs) and High-Interest Savings

Banks issue Certificates of deposits to people willing to have their money tied to the bank for a long time. The investors receive higher interest rates once their account reaches maturity.

High-Interest Saving Account

Owners of high-interest Savings accounts receive interests based on their deposits. The more you put into the account, the higher the interests.

Bonds and Bills

Bonds and bills are institution-backed IOUs. The institution may be government or private corporations, and government bonds are usually low-risk investments that compound well enough.

Dividend Stocks

These are companies that pay regular dividends to their shareholders. They are higher-risk investments because they depend on the company's performance but pay higher.

REITS

These are real Estate Investments that pay out at least 90% of taxable income to investors, and investors can reinvest these payouts to enjoy compounded interests.

Conclusion

Compound interests guarantee an increase not just in the principal invested but also in the interest derived from the principal. Savings accounts and (401)K investments are good examples of accounts with compound interest.


You can calculate your compound interest with a simple formula or a compound interest calculator. Some investments include bonds, bills, CDs, and REITS offer compound interests and moderate risks. When thinking about your investment plan and retirement saving strategies finding the right plan that works for you is extremely important! Additionally, when it comes to your investment strategies its important to keep in mind the relationship between your investments and the taxes that are associated. Contact Diddel & Diddel today to help you strategize your financial future!