Say whaaaaat? You trippinn.
In the online finance community, we talk a lot about these two little words “compound interest”. We know that compound interest is essential in growing our money. But what we really mean is, compounding is essential in growing our money. Not every financial product earns compound interest. Not many financial products can earn interest at all.
Most investments don’t earn compound interest.
I say most because there are ways to earn compound interest on certain methods of investing in bonds. That’s a topic for another time, though.
So let’s get back to basics, how is interest earned? The definition from Investopedia is:
“Interest is the charge for the privilege of borrowing money, typically expressed as annual percentage rate.”
So if a bank borrows money from you, they pay you interest. If you borrow money from a bank, you owe them interest. The reason your savings accounts, CDs, or money market accounts pay you interest is because the bank you have the account with borrows your money to fund loans to other customers until you need it.
Accounts that Earn Compound Interest
- Checking Accounts
- Savings Accounts
- Money Markets
Most investments don’t earn interest. And most investments don’t earn compound interest. When you invest in a company, you aren’t lending the company money. But:
Your investments do compound.
Investment Compounding Methods:
Method 1: Compounding Effects of Dividends
- Reinvesting dividends
- Dividends are paid out per share you own. For example, Year 1, I own 100 shares of Company XYZ, which costs $10 per share. It pays $1 per share in dividends (Dividend Yield = 10%). In Year 1, I’m paid $100 in dividends.
- When you reinvest your dividends, you buy more shares. With that $100 (let’s say it’s not taxed), I can buy 10 more shares, so now I own 110 shares of Company XYZ.
- When you own more shares, you are paid more dividends since dividends are paid per share. In Year 2, I am paid $1 per share on 110 shares, so I make $110 in dividends.
- Dividend growth
- For example, Year 1, I own 100 shares of Company XYZ, which costs $10 per share. It pays $1 per share in dividends. In Year 1, I’m paid $100 in dividends.
- Next year, Company XYZ has become more profitable, so they increase their dividend by $0.05 (Dividend Growth Rate = 5%) from $1 per share to $1.05 per share. In Year 2, I will make $105. If we combine this with the Reinvested Dividends example above, in Year 2, I would own 110 shares of Company XYZ paying $1.05 for each share, so I would make $115.50 in dividends.
Method 2: Compounding Effects of Reinvested Profits
Your investment grows when the the value of what you invested in grows. The value of your investment grows from compounding growth of a company’s revenue and profitability. Simply put:
- Companies earn money, some of which is profit. For example, Year 1, Company ABC earns $100,000 in profit.
- Some of the profit is paid out to shareholders in the form of dividends (Compounding Method #1). Company ABC pays $10,000 (Dividend Payout Ratio = 10%) of its profits out to shareholders in the form of dividends.
- Some of the profit is reinvested in the company. Company ABC keeps $90,000 to reinvest in the company’s operations.
- The reinvested profit allows the company to grow and make more profit. Year 2, Company ABC earns $200,000 in profit because it improved its product with the $90,000 it reinvested. This is Year over Year growth.
- More profit leads to higher dividend payouts (Year 1: $10,000 payout vs Year 2: $20,000 payout) and a higher value in the company (the stock price increasing).
- For example, Year 1, I buy 100 shares of Company XYZ for $10 per share. It costs me $1000 to buy 100 shares.
- In Year 2, Company XYZ becomes more profitable and their stock price goes up 10%. It now costs $11 per share.
Below is a chart of Apple’s revenue growth worldwide from 2004-2016. There’s exponential growth in the company’s revenue because they reinvest in the company to improve their offerings, etc.
What We [The Internet and Financial Literature] Talk About When We Talk About Compound Interest
The term “Compound Interest” in finance articles, literature, or tools refer to compounding in general. They don’t specifically mean compound interest. “Compound Interest” is synonymous with “Compound Growth”, “Compound Returns”, and “Compounding”, but from my personal encounters with it, I think it’s the most commonly used and agreed upon term to represent all of these.
I think this has come to be this way mostly for simplification. It makes the concept of compounding much more approachable and easy to understand instead of overcomplicating it with all the different ways you can get there. When I first thought about it, I found it kind of strange that we refer to it as “Compound Interest” more than we refer to it as “Compounding”, since compounding is a much more inclusive way of talking about it and being factually accurate. Why not just “compounding”? I think for a few reasons:
- Compound interest is a product but compounding is a concept
- Financial institutions sell products and the first financial product most people get earn compound interest in the form of a Savings Account
- SEO compounded the popularity of “Compound Interest” and now even those who distinguish between “Compound Interest” and “Compounding” defer to the more popular keyword in their articles (Note: The title of this page is Compound Interest Calculator, but further down there’s a section saying “Compounding investment returns”, sneaky sneaky!)
When I google “Compounding Calculator”, I get:
Even when I google “Investment Calculator”, I found an Investment Calculator at SmartAsset that lays out my return on investment as “Interest”:
There are tons more examples of this everywhere on the internet. I even googled “do investments earn compound interest”, and still most of the search results list articles talking about the compound interest on your investments when there technically isn’t any. Maybe this is all just a nerdy aside to most people, but I found it super interesting!
Can I Still Use Compound Interest Calculators To Project My Investments?
Yes! Absolutely! At the end of the day, the formula for calculating the effects of compounding is the same.
You may be wondering, what about the different types of compounding an investment earns. How do we roll that all into a single number? We calculate the Annual Compound Growth Rate of an investment which takes into account all your dividend growth, reinvestments, and growth of the investment value. This is the rate of return on our investments we can stick into tools and formulas.
I’d love to hear if you learned something in this article, or if this was news to you! My mind was kind of blown when I discovered how synonymously the internet uses “Compound Interest” and “Compounding”!