Investment compounding explained: How it affects your returns

Here's an experiment: Put $100 into a high-yield savings account and let your money simply sit there. At first, your returns may be relatively modest. But over time the amount of money the bank pays you may start to accelerate, increasing with each passing year (assuming interest rates don't decrease, that is).

What you're witnessing is the effect of compound interest, the formal name for the snowball effect that occurs over a period of years when you start saving your money. It's not just your bank account that benefits, either. If you apply this same concept to securities like stocks and bonds, investment compounding can help maximize your returns and make it easier to reach your long-term financial goals.

Compound interest is a term most often associated with depository products such as savings accounts and certificates of deposit (CDs). It occurs when a bank or other financial institution adds the interest you receive to your original balance before calculating subsequent interest payments.

Say a savings account pays 2% compound interest, which it calculates once per year. If you put $100 into the account and leave it alone, you receive $2 of interest in the first year. Now you have a balance of $102.

Assuming the interest rate on your account stays at 2%, the bank multiplies that rate by your new balance of $102—not your original contribution of $100—to determine your interest payment for the second year. This time, you receive $2.04 of interest, leaving you with a balance of $104.04.

Compound interest contrasts with simple interest, where the payer multiplies the interest rate by your original balance during every payment period. Initially, the difference between the two methods seems small, with compound interest paying just $0.04 more in the second year of the above example. As time goes by, however, the gap becomes more pronounced.

Say you keep that same $100 in your account for 20 years, and it's still accumulating 2% compound interest. Adding interest payments to your principal creates a snowball effect with your money. Now your account is up to $148.59. Had you received simple interest instead, your account would only be worth $140. That's a 21% smaller gain—and needless to say, that gap is much larger with a higher initial investment.

Unlike savings accounts and other bank deposits, bond issuers pay simple interest (although some are sold at a discount and don't pay interest). Say you buy a $500 bond from a company that provides 4% interest. You receive interest payments totaling $20 every year ($500 x 0.04) until the bond reaches maturity.

But even though you receive that same $20 every year, you can simulate the effect of compound interest. Rather than pocketing those interest payments, you can reinvest them to buy more bonds.

That way, not only is that original $500 investment making a 4% rate of return for you, but so is the $20 of interest you used to purchase more bonds. As long as you keep reinvesting your proceeds year after year, the return on your investment can keep growing.

You might be surprised at how big a difference that can make. After 20 years, you receive a total of $400 in simple interest from the bond issuer. But if you reinvest those funds, that number grows to $595.56 of total interest, assuming your new bond purchases also pay out at 4%.

When you own individual bonds in a brokerage account, reinvesting your interest requires a bit of legwork—you have to actively buy more securities every time you receive a coupon payment from the issuer. But when you own bond mutual funds, you may have the option to automatically reinvest those interest payouts to acquire more shares. That lets you take advantage of the compounding effect with little effort.

Stocks don't pay interest, but they can still provide compound returns. Again, it's a matter of reinvesting your proceeds—whether it's a dividend the company pays out or a capital gain from selling shares at a higher price than you bought them. When you use that money to buy more shares, you can achieve the same snowball effect you get with compound interest.

Suppose you own $1,000 of a stock that pays a 5% annual dividend. Assuming you don't buy any additional shares, you receive $50 from the company each year. Now imagine that every time you receive that dividend, you use it to buy more of the company's stock. Those new shares provide the 5% dividend as well, so your gains gradually accelerate over time. In 20 years, your total balance climbs to $2,653.

If you own stocks or stock mutual funds within a brokerage account, you typically have the option to receive dividends when they're paid out or reinvest that money to buy more shares. Choosing the latter option allows you to take advantage of compound returns, which can make a big impact on your long-term savings.

With a retirement account such as a 401(k) or individual retirement account (IRA), that choice is made for you. The plan automatically reinvests any dividends or capital gains from your stock holdings, enabling you to achieve increased investment returns over time.

Multiple factors can affect how much of an effect compounding money may have on your finances. For instance, the larger your investment return—whether it's the interest rate on a bank account or bond or a reinvested stock dividend—the bigger the difference that compounding can make. Likewise, the longer you save or invest your money, the more your returns can grow.

How often compounding takes place can also affect your savings or investment performance—although the effect is often modest. The examples mentioned earlier assume the bank or bond issuer calculates interest only once a year. But in most cases, that's not the way it actually works.

Banks typically calculate interest on savings accounts daily—though they likely credit your account just once a month. That means they take your balance each day and multiply it by the interest rate, then divide it by 365. Daily compounding benefits you because the more frequently the bank adds interest to your balance, the faster your interest payments rise.

Not every depository account works that way, though. The bank may compound the interest on a CD daily, monthly or even semiannually. Check the policy before opening an account since it may affect your return amount. Similarly, bond issuers generally pay interest semiannually, although some do so monthly, quarterly or annually. The more often you're able to reinvest that interest, the quicker your account can grow.

To get a better sense of how compounding can affect your money, consider using the U.S. Securities and Exchange Commission's compound interest calculator. The calculator allows you to adjust the compounding frequency or your hypothetical investment, so you can estimate its influence on your total balance over time.

The idea that you can achieve increasing returns over time is an appealing one, especially with something as large as a retirement account. Here are some of the ways to maximize the effect of investment compounding:

Workplace retirement plans and IRAs reinvest dividends and interest payments for you. If you have a brokerage account, opt to have those earnings reinvested to purchase additional stocks or bonds.

When money's tight, it can be tempting to take a hardship withdrawal or loan from your 401(k). However, there are many reasons to exhaust your other options first—including the loss of compound returns. Whenever you deplete your balance, that money isn't accruing interest, dividends or capital gains that can be reinvested to buy more shares. In effect, you're tapping the brakes on your investment potential.

When you save or invest your money over relatively short periods of time, compound returns may not accrue much. But with each passing year, the value gets bigger. So the earlier you put money into a savings account or invest in a 401(k), for example, the bigger your potential return by the time you hit retirement age.

Because compound returns accelerate over time, prioritizing contributions early in your career is one of the best ways to reach your long-term goals. A Thrivent financial advisor can recommend strategies to boost your savings rate and help you select investments that can maximize compound returns over time.