In the era of high inflation of the last two-years, interest (no pun intended) in compound interest has is once again skyrocketing, as households move to hedge against devalued currencies and rising costs, while also maximizing returns on their savings. Compound interest is as old as interest itself. But while these concepts are pretty recognizable and much has been said and discussed about them, a firm understanding of them is a must when it comes to investing or achieving some of the aforementioned financial goals.
Definitions
While simple interest is the cost borrowing where the interest is accrued on the principal of a loan, compound interest is the borrowing cost where the interest is accrued on the principal AND the interest accumulated over a given period. Think of it really as the interest on the interest over a certain amount of time.
One key element in compound interest is the compound frequency, or how many times does the interest compound per a given unit of time. This frequency could be annual, semi-annual, quarterly, or monthly, etc. The higher the frequency, the greater the return.
How are these calculated?
Simple interest: To calculate the simple interest you just need to multiply the principle by the interest multiplied by the duration of the loan. P x I x T, whereby P= the principal, I= the interest (expressed in decimals), and T=time.
Example: If you borrow USD 1000 at 5% interest for a period of 5 years, the simple interest would be 250. Add that to the principal for a total return of USD 1250.
Compound interest: The following formula is used to calculate the interest compounded over time: A=P(1+r/n)nt, whereby A is the final amount, P is the initial principal, r is the interest rate, n is the number of times interest applied per term and t is the number of periods elapsed.
Example: If you borrow USD 1000 at 5% interest over the period of 5 years that compounds quarterly, the final amount earned would be around USD 1282.
The three levers to maximize compound growth
As we can see, compound interest will always generate a higher rate of return. While the number in the previous example may not that much higher, if you continue to pay into the principal, the returns that can be generated can be much higher, making compound interest much more lucrative than simple interest and a better hedge against inflation. In general, there are three key levers one can pull to maximize returns on compound interest:
- The interest rate: The higher the rate offered on a savings product, the higher the returns, so it is always best to look for higher yield offerings.
- The amount: How much money you add to the initial deposit over a period of time will increase the return.
- Patience: The more you give time you give your deposit time to compound and grow, the greater the return on your investment.
What products are we talking about?
Some of the most popular investment tools used to lock in these higher rates to benefit from compounding interest include:
High-yield savings accounts: These are essentially regular savings accounts that offer higher rates than the much smaller yields offered on regular savings accounts. These, however, usually require much higher minimum deposits on offer. They also aren’t efficient at keeping pace with inflation rising month-on-month.
Certificate of deposits: This is the starter investment when it comes to compound interest. These vehicles payout interest at regular intervals and at higher yields than a regular savings account. The main disadvantages associated with them include a minimum requirement and a lock-up period, where you may not touch the money invested in them for a certain period of time or otherwise you will incur penalties. And just like with high-yield savings accounts, in a high inflationary period, they are a highly inefficient way to keep up with rising inflation.
Money market accounts: As with the first two examples, money market accounts offer higher yields than traditional savings accounts. The main difference is that they allow easier access and handling of your funds by allowing checking and debit card usage.
Bonds: Bonds offer the investor a steady rate of return, with the yields dolled out depending on the default risk of the bond issuer. These yields could be higher than the products named above but are riskier, especially as they are subject to fluctuating market forces. Reinvesting the yields from these bonds would be a good way to tap into the compounding interest benefits. While riskier than savings accounts and CDs, an investor can sell-off the bonds in the secondary market and potentially earn a profit on the initial investment.
Real estate investment trusts (REITs): REITs are companies that own or finance income-producing real estate that payout a dividend to the investors in the trust, with total dividends of around 90% of the real estate portfolio. Investors must reinvest in order to lock in the benefits of compounding investments over time. While the potential for returns is large, REITs are inherently riskier than savings accounts by virtue of real estate being the underlying investment and hence is more likely to be impacted by changing interest rates.
