Savings & Investment

The Compounding Effect

Interest accumulates in different ways on the money you invest in various platforms. Compounding is one popular way in which various institutions determine the amount of interest your investment accrues over time. Compounding is the process in which interest accrues on a certain invested principal amount and the interest already declared. This process, popularly known as the miracle of compounding, is unique due to the aspect of interest on interest, whose effect magnifies interest over time.

Financial institutions such as banks use compounding periods such as annual, monthly, or daily when they decide to credit compound interest to their clients. You may see compounding on investments, whereby savings grow exponentially, or on debt, where the amount owed may grow regardless of continuous payments. This is an interesting phenomenon that directly depends on time, thus bringing to light the concept of the time value of money. This article will dig deeper into the concept of compounding, its effects, and its advantages.

The compounding effect is one that many people prefer when they seek to invest in various institutions; motivation is the gains attributable to this method. This case is no different to companies that offer dividend reinvestment plans that make it possible for investors to reinvest their dividends in return for more shares of stock. Consequentially, this will increase future income from dividends attributed to the increase in shares. Furthermore, another lucrative aspect of compounds referred to as double compounding is where you invest in dividend growth stocks in addition to reinvesting dividends. This case is interesting since you reinvest dividends to buy more shares, and these dividend growth stocks increase the per-share payouts.

The compounding value is directly related to the frequency with which this compounding occurs. The more compounding periods in a given time frame, the more returns. For instance, in the case of one year, having two or more compounding periods is better than having one. The amount that accumulates after every period might be small, but it’s significant in the long run. You can view this aspect using the snowball effect, where a situation of less significance grows exponentially to a more serious state.
Compounding works not only on assets but also on liabilities, which can increase the amount owed on a loan as interest builds up on the unpaid principal and the unpaid interest.

Despite making gradual payments, the amount of interest charges grows continuously, and so does the amount you owe. However, this compounding effect may be unfavorable for credit card balances. Credit cards tend to have higher interest rates, and these interest charges accumulate to the principal balance and incur interest in the future. In this context, compounding is unsuitable for various cases like credit card balances and other instances. Therefore, the effect of compounding may be favorable or unfavorable to you, depending on your financial situation at any given time.

On the other hand, there is a popular rule used to estimate how long your money will double after investing under the compounding effect. The Rule of 72 states that the number of years with which your money will take to double is 72 divided by the interest rate. For instance, your money will double in fourteen years with a five percent interest rate.

Simple interest is another way your money can accumulate after investing in any financial institution. The common word here is interest which; indicates the amount you can earn from what you initially invest. However, this interest can either be simple or compound the difference between the two lying in their names to some extent. Simple interest is more straightforward compared to compound interest. What you only need to worry about when it comes to simple interest is the amount of interest your financial assets accumulate over time. The two interest accumulation principles are key since they suit different situations. When investing, you will want your money to grow faster; that is where the compounding effect comes in. Compounding earns interest on both the principal amount and the interest that accumulates over time, unlike simple interest, which only earns interest on the principal amount.; therefore, when investing, choose a compound interest rate.

On the other hand, it’s common to acquire loans from financial institutions or people. Your lender wants to accumulate more interest on the loan, whereas you want the loan to accumulate less interest with time. Your lender prefers to compound the interest while you want to use the simple interest rate. Since a financial institution has clients as the base of the success of their business, they will want to keep you, and thus many will tend to provide loans at a simple interest rate. With this, its easier to know how much you will repay within a set timeframe and thus make the necessary planning. However, suppose your lender provides the loan at a compound interest rate. In that case, it is advisable to repay the loan within a shorter period, which will neutralize the effect of period compounding. The shorter the compounding period, the lower the loan’s interest rate, thus your advantage.

Finally, compounding has been used for centuries now, and investors, as well as business owners, have embraced its effect. Albert Einstein, a globally recognized influential physicist, referred to this concept as either wonder of the world and its a concept that is pivotal to the financial success of investors. Precisely, if you embrace the compound effect to invest, your money will multiply faster. On the other hand, if you accept compounding as the basis with which you repay a loan, it will take longer to repay the loan than in the simple linear interest concept. Clearly, the compounding principle is lucrative as long as you are at a favorable financial situation. On the bottom line, to accumulate more money on your savings, use the compound interest concept. If you want to accumulate less interest on your loan, go for the institution that offers it with a simple interest rate concept; other factors are constant.