Albert Einstein is nearly universally regarded as having one of the most brilliant scientific minds in history. The iconic man was credited with innumerable compelling statements, including some that can fairly be applied to investing. Einstein, though not a financial advisor, is credited with saying that compound interest is one of the most powerful forces in the universe. In the realm of investing, the power of compounding is manifested through maintaining interest in a bank account. Indeed, the power of interest compounding over time can truly be significant.
The Basic Definition of Compound Interest
The fundamental definition of “compound interest” truly is rather simple. When you compound interest, money earned on a particular investment remains in the investment account. You then earn interest on the interest earned.
Three Underlying Factors that Determine Your Compound Interest Rate
A trio of factors come into play when ascertaining a compound interest rate and how it will benefit you over the long term.
The first of these factors is the interest rate on a particular investment. In addition, the capital gains and dividends on a securities investment are utilized in lieu of an interest rate in ascertaining this initial factor.
Second, the length of time money remains in an investment is one of the key factors in determining the end result. The objective is that the longer you hold an investment the more money you make over time.
Finally, the tax rate and when the tax rate is imposed plays a role in determining the overall benefit of a specific investment. For example, if the investment account if in the form on an IRA, you pay no tax at this juncture in time on interest or other profit gained on the account. Rather, it is deferred to later in life, usually 59 1/2 . And once you retire, your income tax rate should be lower, too.
Examples of How Interest Compounds
The best way to understand the true power of compounding interests is to look at how an investment grows over time when you keep interest in the account. For the purposes of this important illustration, assume that your initial investment is the amount of $10,000. The first illustration involves an investment that earns 4 percent interest. The total value of the investment increases in this manner:
· 10 Years – $14,802
· 20 Years – $21,911
· 30 Years – $32,434
· 40 Years – $48,010
· 50 Years – $71,067
If the investment earns interest at the rate of 10 percent, this is the progress over time when that interest is compounded:
· 10 Years – $21,589
· 20 Years – $46,610
· 30 Years – $100,627
· 40 Years – $217,245
· 50 Years – $469,016
An investment earning compounded interest at 12 percent results in this growth over time:
· 10 Years – $31,058
· 20 Years – $96,463
· 30 Years – $299,600
· 40 Years – $930,510
· 50 Years – $2,890,022
Finally, an investment with an interest rate at 16 percent earns these rates of returns when that interest is compounded:
· 10 Years – $44,114
· 20 Years – $194,608
· 30 Years – $858,500
· 40 Years – $3,787,212
· 50 Years – $16,707,038
Balancing Return and Risk
Of course, when you take a look at this chart of the potential return on a particular investment, you may initially gravitate towards the 16 percent option. The reality is that the higher the potential interest rate on an investment, the greater the risk.
In the end, you likely will want to develop a balanced investment portfolio that includes low-risk options and investments that have a higher rate of return or ROI but also present a larger risk as well. In addition, if you are younger you arguably have time available to withstand and recoup from a loss associated with a riskier investment should that type of downturn occur.
In contemplating what steps to take in regard to investing your hard earned money and planning for your future, don’t rule out the possibility of seeking assistance from a financial advisor. A Financial Advisor can provide you important insights on what types of investments do and don’t make sense for you.