How to Take Advantage of the Power of Compound Interest

by biesingerfirejourney | May 29, 2022 | Make & Invest

You’ve probably heard the term “compound interest” before, but do you know what it actually means? In essence, compound interest results when an investment’s earnings are reinvested so they can earn interest on their own.

The result is a snowball effect that can lead to significantly increased earnings over time. We love compound interest so much because it has allowed us to reach COAST Fire; for more on this story, check out Coast FIRE: The Easiest Way to Join the FIRE Movement.

In this article, we will discuss what compound interest is and how it works. We’ll also look at some examples to help illustrate the concept.

This post may contain affiliate links; please see our disclaimer for details.

What Is Compound Interest?

Let me explain compound interest by examining how it differs from simple interest.

With simple interest, you only earn interest on the principal or original investment. However, you can calculate compound interest on both the principal and any accumulated past interest. This accrued interest is then added to the principal sum, and the new total becomes the base upon which future compound interest calculations are made.

In other words, compound interest is calculated on both the principal and the accumulated past interest.

Simply put, compound interest is the interest you earn on your initial investment plus the interest you earn on any previous interest that has been added to the account.

Compound interest in retirement planning is important because it can dramatically impact an investment’s growth over time.

Compounding works best when you start early and allow the amount to continue for a long period.

The waiting process takes time. However, the effects are POWERFUL.

Think of compound interest as “interest on interest.”

With compound interest, you earn money on your original investment and the interest that has accrued. The more frequently interest is paid or compounded, the greater the impact on the principal sum.

Where can your money’s interest be compounded?

The most common investment that compound interest works with is a savings account.

The bank pays you interest when you deposit money into a savings account. You can see a payout for the interest typically once per year.

However, some banks offer accounts that compound interest more frequently, such as monthly or daily.

With these types of accounts, the interest in one period adds to the principal sum. You can then calculate the interest for the next period on this new total.

You can also use the formula to assess other assets, such as stocks, bonds, and ETFs. These can be invested in using a brokerage or retirement account.

Although the calculation may be a little off as these asset variables are constantly changing, it can still give you a good idea of what you could expect in the long run.

To summarize, compound interest allows investors to make money by reinvesting their earnings and allowing them to grow over time. This growth can be significant, especially when the account compounds over a long period.

You can even support the compounding effect by including a DCA strategy. In brief, a DCA (dollar-cost-average) strategy is an investment technique in which an investor breaks up a lump sum of cash into smaller investments, buying them over time.

This technique can help reduce the effects of volatility on your investment portfolio and take advantage of market dips to buy assets at a lower price. When combined with compounding, a DCA strategy can profoundly affect your portfolio’s growth.

What Is the Formula for Compound Interest?

We can calculate compound interest using the following formula: A = P(l+r/n)^nt

Variables:

A = the future value of the investment: This is the total amount of money you earn from the investment.

P = the principal investment amount: This is the original sum of money you use to invest.

l = the annual interest rate: The yearly rate at which interest will be earned on the investment.

r = the periodic interest rate: Divide this number by n

n = the number of times that interest compounds per year: This can be monthly, quarterly, semi-annually, or annually.

t = the number of years the money for the investment: This is the length of time that the investment will grow for.

As you can see, several factors go into calculating compound interest. To influence the variables to your favor, focus on finding investments with consistently high-interest rates that compound frequently.

You can also start with a larger principal amount and be willing to wait for more years.

The incredible thing about compound interest is that math accurately predicts how much an investment will be worth in the future.

Compounding is a geometric progression, meaning that each successive year, the interest earned grows faster.

However, the prediction may be wrong only because of human nature. Panic selling,  reinvesting at the wrong time, or letting fees eat into returns, can all reduce the final value of an investment.

So, while the math works, other external variables are in your control. Understanding both math and psychology is important to successful compounding.

The formula can be overwhelming to look at. Luckily you do not have to be a math wizard to be able to calculate your potential compound interest. Many online calculators can do the work for you.

In the next section, we’ll simplify the formula with an example of how it works.

How Does Compound Interest Work?

The effect of compounding can be significant. For example, let’s say you have a savings account that pays you simple interest at a rate of five percent per year. After one year, your total balance, including interest, would be $105 (the original $100 plus five percent, or $105).

But if your interest compounds annually–meaning that the interest adds to the account at the end of each year and becomes part of the principal–your balance after one year would be $110.25.

The next year, you would earn interest not only on the original $100 but also on the $105 from the first year, for a total of $110.25. As you can see, compound interest has a snowballing effect and can add up over time!

All in All

Investing works best when it compounds. This is because compounding is a geometric progression, meaning that each successive year, the interest earned grows faster.

Compounding can have a significant effect on the growth of your portfolio. Make sure to keep this in mind when making investment decisions.

The longer you invest, the more pronounced the effects will be. This is why it’s important to start investing early and to have a long-term investment horizon.

Compound interest is often referred to as “the eighth wonder of the world.”

Albert Einstein says it is “the most powerful force in the universe.”

While compound interest can work wonders, it’s important to remember that it is a slow process. The compounding effects are not immediately noticeable, and it can take years for your investments to reach their full potential.

Patience is key when investing, but the rewards can be great if you’re patient and disciplined.

Compound interest is a powerful tool that can help you grow your wealth over time. By understanding how it works and using it to your advantage, you can build a bright financial future for yourself and your family.

It’s never too late to start investing. The earlier you start, the more your wealth will compound!

Disclaimer:

We hope the information in this article provides valuable insights to every reader but we, the Biesingers, are not financial advisors. When making your personal finance decisions, research multiple sources and/or receive advice from a licensed professional. As always, we wish you the best in your pursuit of financial independence!

What The Fed Raising Interest Rates Means for Buyers, Sellers, and Homeowners

by biesingerfirejourney | May 28, 2022 | Make & Invest

The Federal Reserve (the Fed) is raising interest rates. This is an important event that will significantly impact the housing market in the United States.

This article will look at what the Fed rate hikes mean for home buyers, sellers, and homeowners.

This post may contain affiliate links; please see our disclaimer for details.

What’s the Federal Reserve?

The Federal Reserve is the central banking system of the United States. Congress created it in 1913 in response to a series of financial panics that plagued the country.

The Fed’s primary responsibilities are:

• Promote economic growth and stability
• Supervise and regulate banks and other financial institutions
• Provide financial services to the government and the public.

The Fed is often referred to as “the lender of last resort.” This is because they can provide loans to banks when they are experiencing difficulty obtaining funding from other sources.

They are not federal entities at all but are quasi-public entities. Its creation was to serve as a buffer against financial panics and recessions. There are a lot of divisive opinions about this establishment.

One perspective is that the fed is too powerful. The rate of currency creation can raise inflation, making it more difficult for consumers to save money. Many people that live paycheck to paycheck resent this inflationary pressure.

When the federal reserves increase the inflation rate, savers lose their currency’s value. Borrowers make money by taking advantage of low debt costs to invest in assets.

The Fed manipulating interest rates can have widespread effects. For example, one of the reasons for the subprime mortgage crisis in 2008 was caused by the Fed keeping rates artificially low for too long. This led to a housing bubble which eventually burst, causing a financial crisis.

An opposing perspective is that the fed isn’t powerful enough. The fed’s primary tool is interest rates, and there are limits to how low they can go before hitting zero.

This means that the Fed doesn’t have a lot of room to maneuver when it comes to stimulating the economy.

The decision of the Fed to raise interest rates will have different effects on different groups of people. Make sure to keep reading to find out how it affects you.

What Does the Federal Reserve Do?

The Federal Reserve performs several important functions, but its two main goals are:

1. Promoting maximum employment
2. Stabilize prices (inflation). The Fed does this by setting interest rates.

When the economy is strong, and inflation is low, the Fed will raise rates to prevent the economy from overheating. Conversely, when the economy is weak or inflation is high, the Fed will lower rates to stimulate economic growth.

This incentives investors and business owners to borrow currency to reinvest into the production of goods and services.

The Federal Reserve also regulates banks and other financial institutions to promote stability in the financial system. By controlling the banking systems, the Fed can influence the availability of credit and the cost of borrowing. This lending helps to prevent bank failures and maintain confidence in the banking system.

As a real estate participant, this affects you. When banks have more confidence, they are more likely to lend money, and when borrowing costs are low, it affects your mortgage rate.

Unless you are paying for the property in 100% cash, the interest rate on your mortgage directly correlates with the Federal Reserve’s actions.

When the Fed raises rates, it becomes more expensive for banks to borrow money. As a result, banks will raise the prime lending rate. This is the rate at which banks lend money to their best customers.

The prime lending rate is used as a benchmark for other rates, such as the rate for a home equity line of credit (HELOC) or a 30-year fixed mortgage.

The Fed’s decision to raise interest rates will affect different groups of people differently.

Homeowners with adjustable-rate mortgages will see their monthly payments go up. The same is true for people with home equity lines of credit and student loans. On the other hand, savers will earn more interest on their deposits.

Why Is the Fed Raising Interest Rates?

The main reason why the Fed is raising interest rates is to keep inflation in check. When the economy is strong and growing quickly, prices for goods and services tend to go up.

The Fed’s goal is to raise rates just enough so that inflation stays healthy, but not so much that it slows down economic growth.

As mentioned earlier, the Fed is raising interest rates to prevent the economy from overheating. When the economy is doing well, it can sometimes lead to too much growth. This can cause problems, like what happened in 2008 when there was a housing bubble. The Fed can slow economic growth and prevent these bubbles from forming by raising rates.

Finally, the Fed is raising interest rates to normalize monetary policy. The Fed has kept rates at historically low levels for the last few months to stimulate economic growth. Now that the economy has started to recover, it’s time for rates to return to a more normal level.

How does the Federal Interest Rate Increase Affect Home Buyers?

As a home buyer, you may wonder how the Fed’s decision to raise interest rates will affect you. The most immediate effect will be higher mortgage rates. If you are shopping for a home, you may want to consider locking in a rate now before they go up any further.

If you have already been pre-approved for a mortgage, you may still be able to lock in a lower rate if you act quickly. The good news is that even with higher rates, your home can still be an asset if you rent out space in your new home. A larger down payment can also help alleviate the debt burden.

In the longer term, the Fed’s decision to raise interest rates could impact home prices. When rates go up, borrowing money becomes more expensive, which can lead to slower economic growth. This could cause prices to rise slowly or even fall in some markets.

Of course, the Fed’s decision is just one factor that can affect home prices, so it is impossible to say exactly how this will play out. If you are considering buying a home, it is important to research and talk to a financial advisor to get the best advice for your situation.

To summarize, the effect on home buyers is more complicated, but there are two main ways that higher interest rates will influence buying decisions:

Homebuyers who were on the fence about whether or not to buy may now decide to wait because their monthly mortgage payment will be higher than it would have been otherwise. This could lead to lower demand for homes and put downward pressure on prices.

On the other hand, higher interest rates could lead to more people wanting to buy now because they are worried that prices will go up even further in the future. This could increase demand for homes and put upward pressure on prices.

It is impossible to say definitively how the Fed’s decision will affect home buyers, but it is important to be aware of the potential implications before making any decisions.

Related Content: 15 Expert Tips to Get Approved for a Mortgage.

Related Content: 15-Year vs 30-Year Mortgage: How to Decide.

How does the Federal Interest Rate Increase Affect Home Sellers?

Home sellers are not likely to see an immediate or significant change due to the Fed’s interest rate hike. However, over time, higher interest rates could make it more difficult for buyers to afford a home, leading to fewer sales.

Another way that higher interest rates could affect home sellers is by influencing the decision of whether or not to buy a replacement home. If you are considering selling your home and buying another one, you may consider doing so sooner rather than later. This is because it will likely be more expensive to finance a new purchase when interest rates are higher.

Finally, it is important to remember that the Fed’s decision is just one factor that can affect the housing market. Other factors, such as job growth and the economy’s overall strength, will also play a role in determining whether now is a good time to sell your home.

If you are considering selling your home, it is important to talk to a real estate agent to get the most up-to-date information on the market in your area.

It can be difficult to know what to expect in the current market, but a real estate agent can give you the most accurate advice.

In summary, while higher interest rates may eventually lead to fewer sales, it is not likely to significantly impact home sellers in the short term.

However, if you are considering selling your home and buying another one, you may want to do so sooner rather than later.

How does the Federal Interest Rate Increase Affect Homeowners?

As mentioned, homeowners with adjustable-rate mortgages (ARMs) will see their monthly payments go up.

For example, if your rate is currently at a low rate of three percent, and the Fed raises rates by a quarter-point (0.25%), you would see your interest rate jump to three and a quarter percent. And that could continue to rise as the Fed raises rates in the future.

If you have a fixed-rate mortgage, your monthly payments will stay the same for the life of your loan. Homeowners in this situation have less to worry about with the Fed interest rate hikes.

It’s important to know how much the interest rate will rise and if you can still afford the monthly payments. You may need to start looking at ways to cut costs in other areas of your budget. Raising your income is also a possibility. You may want to consider refinancing your mortgage to lock in a lower interest rate if rates continue to rise.

Final Thoughts

In conclusion, the Federal Reserve’s decision to raise interest rates will have different implications for home buyers, sellers, and owners. Before making any decisions, it is important to be aware of how this could affect your situation.

Understanding what the Federal Reserve does and how its decisions affect the economy is important regarding your financial future. The most important thing to remember is to consult a financial advisor to get the best advice for your situation.

It’s also important to continue learning more about economics and how it affects your finances. Knowledge is power, whether you are a real estate investor, home broker, or mortgage borrower. Check out other articles published on this website to improve your financial IQ.

Disclaimer:

We hope the information in this article provides valuable insights to every reader but we, the Biesingers, are not financial advisors. When making your personal finance decisions, research multiple sources and/or receive advice from a licensed professional. As always, we wish you the best in your pursuit of financial independence!