Updated: Apr 24
1+1+1+1=5.1.... Triggered yet?
That's at a 10% return!
Compounding Returns – What you Must Know
You hear people talking about compounding returns when discussing savings accounts and investments. It sounds complicated and if you didn’t have a basic personal finance course in high school, you may not know what it is, but you should.
Compounding returns are your path to reaching your financial goals. When your returns compound, they grow. And what better way to reach your financial goals than letting your money grow? Your money growing while you're not working means you get more time to do the things you love.
What are Compounding Returns?
To earn compound returns, you must make a contribution whether to your interest-bearing savings account, 401K account, or taxable investment account.
Over time, your contribution grows. Whether you earn interest on your savings account or the dividend stock you invested in pays out, you have more money in your account. If you leave the money in the account, it will continue to grow, but this time it’s not just your contributions earning money, but your earnings grow too.
Here’s a simple example.
You have $100 to invest. If you put it in a savings account for a month and it earns interest and then you withdraw the entire amount, your earnings don’t have time to compound. But, if you leave the money in the account, your balance earns interest and then your interest earns interest.
The same is true of an investment, such as stocks. If you buy $100 worth of stocks and in six months they pay out a dividend, you have two options. You can take the cash and pocket it or reinvest the cash, buying more of the stock, allowing your earnings (the dividends) to grow.
How do They Work?
Let’s look at an example of how they work using simple numbers.
You have $1,000 invested and a 5% annual compound interest. At the end of year one, you’d have $1,050, which is your $1,000 contribution plus $50 interest. You would then earn interest on the full $1,050 for the next year.
In year 2, you’d have $1,102; year 3 $1,157; year 4 $1,214, and year 5 $1,275. As you can see, the amount earned grew each year by more than $50, the original interest because of compounding returns.
The Different Ways Compounding Returns works
Compounding returns works on deposit accounts like savings accounts and CDs, and certain investment accounts, such as dividend stocks. An investment can earn compounded returns only if it pays out in some way, such as interest payments or dividends from stock ownership.
Common compounding returns products include:
· Dividend-paying stocks – When companies do well, they share some of their profits with dividend stockholders. If you receive the dividends and reinvest them, you compound your earnings because you own more of the stock than you did when you first invested. You can keep letting your earnings earn money by reinvesting your dividends.
· Mutual funds – Many mutual fund managers invest in dividend-paying stocks. When the stocks payout, the mutual fund manager uses the funds to buy more dividend-paying stocks, allowing the returns to grow.
· ETFs – Exchange-traded funds work like mutual funds but on a smaller scale. If your ETF invests in dividend-paying stocks, the ETF manager may take the funds and buy more stocks, instead of paying the money to you.
· CDs – When you deposit money into a CD, you leave it for a predetermined amount of time and have an interest-paying schedule. When the bank pays interest, you could receive it as cash or reinvest the interest into your CD, compounding your earnings.
· Capital gains – You can even make your capital gains earn money or compound. When you sell an asset for more than you bought it for, you earn capital gains. If you take the capital gains and invest in another asset, you compound your earnings because you didn’t take the cash.
The best way to take advantage of compounding returns is to start today. Every dollar you invest today will be worth more tomorrow. But if you wait until tomorrow, that same dollar is worth less money.
Compounded earnings need time to make the ‘magic’ work. Figure out investments or even savings products you can use and leave your money in the account. Don’t touch the money – let it grow and watch compounding magically happen before your eyes.
If you use compounded earnings, you’ll need to contribute less money to reach your financial goals, but will still reach them with the power of your growing earnings.
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