Compounding: Use it to build your wealth

There are several ways to earn income on investments, but compounding may be your most reliable path to wealth. If you put $1,000 under your mattress, it will still be $1,000 a year later, but it probably will buy you a little less due to inflation.

If you lend the money to a friend at 12% simple interest, at the end of the year you’ll receive $1,000 plus $120 of interest, since simple interest is computed only on the principal.

Compound interest

Compound interest is computed on both the principal and the interest earned. If you invest the $1,000 in a bond that earns 12% interest compounded monthly, in the first month it will earn 1% (1/12 of 12%), or $10. Now you have $1,010, which will earn 1% interest in the following month, only now the earnings will be $10.10. At the end of the third month, you’ll earn 1% interest on $1,020.10 ($1,000 plus $10 plus $10.10), and so on. By the end of the year, you’ll have $1,126.83, or $6.83 more than you would earn if you loaned out the money at the same rate but at simple interest.

Time matters

An additional $6.83 doesn’t sound like much, but things change over time. After 10 years at 12% simple interest, your $1,000 would be worth $2,200, which is the original $1,000 plus 12%, or $120, multiplied by 10 years. At 12% interest compounded monthly for 10 years, your $1,000 would be worth $3,300, or half again as much as it would without monthly compounding. After 30 years, your $1,000 would be worth $35,950!

Rate of return is also important. Since after 10 years your $1,000 would be worth $3,300 at 12% interest compounded monthly, it would have earned $2,300. At 6%, after 10 years the $1,000 would be worth $1,819, earning only $819 rather than $2,300.

Now suppose the $1,000 came from your net wages. If you’re in a 25% income tax bracket, you earned $1,333 to get $1,000 after taxes were withheld. But what if you could have invested the entire $1,333 for 10 years? Then you will have an additional $1,100.

Compound benefits

The above examples suggest the following ways to use compounding to increase your earnings:

• Start saving and investing now. Time is your most powerful multiplier.
• Shop for the best rates of return, consistent with your risk tolerance.
• Set up your investments to automatically reinvest interest and dividends earned.
• Use tax-deferred programs like IRAs and 401(k) plans to the fullest possible extent.

If you’d like to learn more about compounding, just give us a call. We’ll be happy to review the numbers that apply to your business and investment decisions.