Examples of Compound Interest in Real Life

Compound interest can be defined as the interest that is earned on both the money saved as well as the interest money. To understand the concept of compound interest better, one must understand the meaning and significance of interest. Interest can be defined as the amount of money that a financial organisation receives from a borrower or pays to a customer as a reward for their services. For instance, consider the example of a savings account, the amount of money that the owner of the savings account receives yearly as a reward for keeping money with the bank is typically the interest amount. Interest is usually expressed as a percentage value and gets accumulated with the base amount on a yearly basis. The rate of interest usually depends on the amount of money available in the bank account. Here, in this case, the interest is called simple interest as it gets applied to the principal amount of money only. On the other hand, in the case of compound interest, the interest is earned on the principal amount of money deposited in the bank as well as the interest amount earned on the saved principal amount. As a result, the interest gets compounded over and over with every passing month or year, hence the name compound interest. Germany born theoretical physicist Albert Einstein once said that compound interest is the eighth wonder of the world. According to him, the person who understands the concept of compound interest benefits and earns from it, while those who do not have sufficient knowledge of the subject tend to pay it off. In other words, compound interest can be defined as the interest that a person tends to earn by reinvesting the principal amount of money and the earned interest on the existing principal amount of money into the same financial organisation. Compound interest is advantageous as it tends to accelerate the growth of savings and investments over time at a rapid rate in a non-complex manner and is disadvantageous as it tends to inflate the debt amount that you owe a person or an organisation over time.

The formula that can be used to compute compound interest is usually given as, A = P (1 + [r / n]) ^ nt, where A is the total amount of money accumulated in n years, including the principal amount as well as the interest amount, P is the principal amount or the initial deposit money or the initial balance amount, r is the annual rate of interest, n is used to denote the number of times the interest gets compounded every year, and t is time or the number of years that the principal amount of money is deposited for in a bank or any other financial organisation. In the case of compound interest, the annual interest rate depends on the frequency of compounding, hence the rate of interest parameter gets divided by the number of times it gets compounded in a year. This provides the user with an insight into the daily, monthly, or annual average interest rate.


Examples of Compound Interest

There are a variety of investment models and financial processes that make use of compounding or application of compound interest in real life. Some of the examples of compound interest in real life are given below:

1. Bank Accounts

Bank accounts such as saving accounts or checking accounts tend to employ the concept of compound interest in real life. Saving accounts and checking accounts are quite similar to each other in operation and differ on the basis of the fact that a savings account is primarily used for the purpose of saving money for a significantly longer duration of time, while the checking account is used for daily use and is preferred for applications that require a much more frequent withdrawal and deposit of assets. When you deposit money in different bank accounts, the bank tends to provide interest money on a yearly or monthly basis as reward money to the customer or the owner of the account. The interest amount can be withdrawn or can be allowed to accumulate with the principal amount. If the owner of the account withdraws the interest amount, the money in the account receives simple interest, while in case the interest gets accumulated with the principal amount, it receives compound interest.

2. 401(k) Accounts

401(k) accounts tend to fall under the category of tax-deferred retirement savings accounts. A 401(k) account is generally offered to employees by their employers. This particular retirement plan allows the users to save a portion of their salary before paying the taxes. If the owner or the consumer invests the money available in his/her 401k account into something, the growth helps in the generation of returns from savings. The returns can further be reinvested back into the same account to generate more returns, thereby compounding the returns.

3. Credit Cards

Credit cards tend to form yet another example of compound interest in real life. A credit card is a piece of thin rectangular-shaped card made up of plastic or metal issued by a bank or a financial company. Credit cards primarily allow the users or consumers to temporarily borrow funds directly from the federal institutions and easily pay the merchants that accept payments through such cards. In simple words, a credit card can be thought to be a type of short term loan. Each credit card assigned to a consumer is provided with a set credit limit that keeps on decrementing with every freshly made purchase or recent transaction. The credit limit denotes the upper limit of the amount that the financial institutions allow the user to spend in a given period of time. The credit limit varies from user to user and is generally decided on the basis of the consumer’s requirements or spending habits. Credit card providers generally make use of the concept of compound interest to evaluate the amount that they will charge the customers on the borrowed money. The interest rate on the borrowed money gets compounded every day and depends primarily on the average daily balance.

4. Certificates of Deposit (CDs)

A certificate of deposit is a federally issued time deposit that is usually provided by banks or financial institutions for the purpose of investment, saving, and earning. A certificate of deposit is considered to be one of the safest forms of investment. CDs usually have a fixed rate of interest assigned to a particular amount of money for a set time duration. The rate of interest applied to a certificate of deposit account is generally higher than the rate of interest of a savings account. The money deposited in CDs gets tied up for a particular time. If the user does not withdraw the money till the maturity time period is achieved, the principal amount gets accumulated with the interest amount. The interest, however, is received at regular intervals of time and the combination of the principal amount and the interest can be retracted at any point in time. If the user does not retract the money even after the maturity time period is attained, the deposited money and the interest amount get accumulated and compounding of the interest on the existing principal amount and interest can be observed. The compound interest keeps on building on the total amount of money present in the account over and over till the user withdraws the money.

5. Investment Accounts 

An investment account is basically an account that keeps a track of the investments made by the user in different markets places and maintains the record of profit or loss. The investment accounts allow investment in stocks, ETFs, mutual funds, bonds, etc. The profit or the loss amount earned or lost on the principal amount typically follows the concept of compounding, hence the investment accounts can be listed under the category of applications that make use of compound interest for their basic operations. The gain or loss of the stocks and other relevant investment modules is generally represented in the form of percentages. The performance percentage is computed on the basis of the performance of the previous day. This implies that such investments get compounded every business day. The key to growing faster in such investments is to reinvest the dividends and make regular deposits.

6. Rental Homes 

Rental homes and properties are one of the best forms of investment that can help a person attain passive income with ease. The real estate compounding is quite similar to that of a dividend stock investment. In the case of dividend stocks, the user tends to use the dividends from a stock to buy more stock. Similarly, in the case of rental properties, the consumer tends to reinvest the profit earned from one property into an additional rental property, thereby leading to the accumulation of profit amount and the compounding of wealth earned over a period of time.

7. Stocks

A stock is a type of security investment that basically represents the ownership of a fraction of a corporation or an organisation. The investment in stocks is usually made in terms of units of stock called shares. A stock is also known as equity. As per the value of the stock owned, the owner of the stock is generally entitled to a proportion of the organisation or corporation’s assets and profits. Stocks can be broadly classified into four categories, namely, growth stocks, dividend stocks, defensive stocks, and new issues or initial public offerings (IPOs). The stocks that pay dividends tend to generate compound interest if you reinvest the dividends and buy more shares, hence investing in stocks serves to be a classic example of compounding in real life.

8. Bonds

Bonds can be defined as a form of security investment in which a borrower seeks money from an individual or a financial organisation for a set duration of time. The borrower is supposed to return the principal amount of money as well as the interest amount within the assigned duration of time to the lender. In the case of bonds, the interest is generally paid regularly at fixed intervals, while the principal amount of money can be repaid at the maturity date. Bonds tend to form an excellent example of investments that make use of the concept of compound interest in real life. The interest rate in the case of bonds gets accumulated or compounded semi-annually. This means that every six months after the bond’s issue date, the interest earned by the bond in the previous six months gets added to the principal value or the base value of the bond. The accumulated value is further considered as the new principal value and now the interest is earned on the new principal amount. The process goes on and on till the maturity date of the bond is reached or till the user withdraws the money. The investments made in bonds are somewhat risky and are not considered to be as safe as other forms of financial investments. This is because bonds are generally subject to fluctuations in the economy. On the other hand, the advantage of investing in bonds is their property of liquidity which stands to be quite beneficial for the investors.

9. Loans

A loan is basically an amount of money that a person or an organisation tends to borrow from a lender for a particular duration of time and accepts to repay the amount after the stated time duration with interest. On the basis of the purpose, loans can be classified into different types such as student loans, home loans, car loans, gold loans, personal loans, business loans, etc. Loans tend to make use of the concept of compounding, but here, the compound interest tends to work against the borrower’s interest. If the borrower fails to pay the loan money with interest in time, the moneylender organisation or individuals save rights to charge huge interest on the existing interest on the principal borrowed amount as the time passes. This means that the loan debt tends to accumulate compound interest. In the case of loans, to reduce the compounding of the parent amount or the total money, a portion of the principal amount must be paid every month.

10. Treasury Securities

A Treasury Bill or T-Bills are the short-term debt instruments or obligations backed by the government of a nation. The interest rate applied on treasury bills is generally determined by the current state of the market. T-bills are provided to the consumer with a maturity time period of one year or less. The longer the maturity time period, the higher the interest rate that the T-Bill is required to pay to the investor. Treasury bills are usually issued when the government needs money for a short period of time to invest in the new projects, plan new policies, and/or pay debts. Treasury bills typically have a fixed interest rate that does not vary according to time; however, a percentage of the amount gets added to the original amount every six months to cover inflation. This indicates the application of the concept of compounding. The user tends to earn interest on the base amount, which further gets added to the original value of the bill on a monthly basis, thereby increasing the value of the bill as time passes by.

11. Mortgages

A mortgage can be defined as a legal agreement between a financial institution and an individual or an organisation to lend money to the consumer with a particular interest rate in exchange for a property or a valuable item. In case the consumer fails to repay the loan amount with interest to the lender in a given amount of time, the lender is allowed to take legally transfer the ownership of the property or valuable item on stake to his/her own or the organisation’s custody. The term loan and mortgage appear to be similar but are different as the word mortgage refers to a stationary or immovable property that is used as collateral to avail the money, while the loans can be collateral-free. Most mortgages employ the concept of simple interest to evaluate the interest amounts; however, the mortgages that allow negative amortization depends on the concept of compound interest.

12. REITs

Real estate investment trusts (REITs) serve to be yet another example of the application of compound interest in real life. REITs are the organisations that own and operate real estate. The task of a real estate investment trust is to extract passive income with no or minimum requirement to manage the property. Basically, there are five forms of REITs in the market, namely retail REITs, residential REITs, healthcare REITs, office REITs, and mortgage REITs. According to IRS, the REITs are required to pay approximately 90% of their taxable income to the shareholderes, which is why the REIT dividends are much higher as compared to the average stock. Compounding these high-yield dividends form one of the best ways to make passive income.

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