Compound Interest Investing (3 Ways to Maximize Your Returns)

How does compound interest investing work, and what are the results? In this post I’ll go over how compound interest investing works, including three ways to maximize your compound interest.

Simple Interest

With simple interest, you receive interest payments based only on your initial investment. After each pay period, you’ll receive the same amount in simple interest.

Compound Interest

With compound interest, you receive interest payments based on your initial investment and any cumulative interest payments. 

Here’s an example with an initial investment of $1000 and interest rate of 10%:

As you can see, with compound interest you get interest on your interest. So you collect more interest on your interest.

In this example, you’ll collect $1594 in compound interest, vs. $1000 in simple interest. This is 59.4% increase in interest!

Over a longer period of time, it’s evident how staggering the exponential growth becomes.

When you invest in a savings account that pays interest, or you reinvest your dividends received from a stock or index fund, you too are reaping the benefits of compound interest.

More money grows on more money.

Compound Interest Formula:

The compound interest formula is ((P*(1+i)^n) – P), where P is the principal, i is the annual interest rate, and n is the number of periods.

Example: If your principal investment is $1000, invested at annual interest rate of 6%, after 3 years you’d have:

((1000*(1+.06)^3)-1000))

= $191.01 in compound interest

Compound Interest Calculator

If you don’t have a calculator handy, you can use this online Compound Interest Calculator from investor.gov.

Maximize Your Returns

Method #1: Invest Early

You can take even greater advantage of the exponential nature of compound interest by investing early or the staying invested longer.

Look what happens when you invest early:

In this example, Jack contributed in total $24,000 to his investment, meanwhile Jill contributed $72,000 total. Even though Jack stopped making contributions at age 35, he still outperformed Jill because he started investing ten years earlier than her. His contributions had more time to grow and more time to collect more compound interest.

Method #2: Invest Longer

What happens when Jack continues to contribute to his investment until he reaches age 65?

Jill makes contributions for 30 years and turns $72,000 until $250,000, a profit of $178,000. Not bad…

But Jack makes contributions for 40 years and turns $96,000 into $525,000, a profit of $429,000!!

By investing just ten years longer than Jill, Jack would have over $500,000!

Method #3: Make it Automatic

Make your money work for you automatically but allowing your brokerage to automatically re-invest your dividends. That way, you dividends will be used to purchase more shares, and those shares will soon be earning more compound interest.

If you don’t re-invest your dividends, your dividends will just be distributed to you in cash, sitting in a money market fund not earning much at all in interest.

Here’s what the selection looks like in Schwab when purchasing stock:

You want to make sure that the Reinvest Dividends box is selected.

When you purchase mutual funds, the fund may produce not only dividends but also any capital gains from sales.

To once again maximize your compound interest buy purchasing more shares, I recommend you click the option to reinvest both dividends and capital gains:

Conclusion:

Don’t fall into the trap of “Oh I’ll just invest tomorrow”. Or I’ll wait until I’m 35 or 40 to start investing. To take advantage of the power of compound interest, you need to start investing today because compound interest growth is exponential.

One of the easiest ways to capitalize on compound interest growth is to automatically reinvest dividends and capital gains.

The longer you stay invested, the faster your money will grow. Once you understand how compound interest investing works, you can use this knowledge to grow your money and bring you closer to financial freedom.

Let me know your thoughts:

How are you currently taking advantage of compound interest?