Compound Interest in Life Insurance: What You Should Know

You’ve heard about it often enough, most likely when choosing a 401(k) investment, but compound interest can multiply your money. The name of the game with compound interest is time, and the more of it you have, the bigger the payoff. That means if you’re a short-term investor, or looking to stay mostly liquid, then this strategy is most likely not best-suited for you. Let’s more discuss more about compound interest in life insurance:

What is compound interest?

Compound interest is the interest you earn on interest. In short, you make an initial investment and receive a particular rate of return your first year which then multiplies year over year depending on the interest rate received.

Let’s say you make a $100 investment and receive a 7 percent rate of return in your first year. The interest has not yet compounded as you are in the beginning stage of the investment.

But then, during the second year you net another 7 percent return on that same investment. This means your original $100 grows as follows:

Year 1: $100 x 1.07 = $107

Year 2: $107 x 1.07 = $114.49

The $0.49 is compounded interest earned from the first to second year, as it is interest earned on top of the initial $7 in interest earned after the first year. The $7 gained in year one is simple interest. After this initial simple interest, that’s when the interest starts earning interest which is what is defined as “compound interest.”

This might not seem like a lot, but compound interest truly takes off in long-term investment accounts.

For the sake of the example, let’s assume an account with a balance of $20,000 and an average return of 7 percent (10 percent is about the historical average return for the S&P 500 since its inception, and 7 percent can be thought of as relatively conservative.)

Year 1: $20,000 x 1.07 = $21,400

Year 2: $21,400 x 1.07 = $22,898

In two years, you will have gained almost $2,900 with $98 compound interest — simply by keeping it invested.

 Understanding compound interest in life insurance

When calculating compound interest in life insurance, you need to understand a few key factors. Each plays its role in the end product, and some variables can drastically impact your returns. Here are the five key variables involved in understanding compound interest:

– Interest:

 This is the interest rate you earn or are charged. The higher the interest rate, the more money you earn or the more money you owe.

– Starting principal:

How much money are you starting with? How big a loan did you take out? While compounding adds up over time, it’s all based on the initial amount you deposit or borrow.

– Frequency of compounding:

The pace at which interest is compounded—daily, monthly, or annually—determines how rapidly a balance grows. When taking out a loan or opening a savings account, make sure you understand how often interest compounds.

– Duration:

How long do you anticipate owning an account or paying off a loan? The longer you leave money in a savings account or the longer you hold on to a debt, the longer it has to compound and the more you’ll earn—or owe.

– Deposits and withdrawals:

Do you anticipate making regular deposits into your account? How often will you make loan payments? The pace at which you build up your principal balance or pay down your loan makes a big difference over the long run.

 Fact:

Some banks also offer continuously compounding interest, which adds interest to the principal as regularly as possible. For practical purposes, it doesn’t accrue that much more than daily compounding interest unless you want to put money in and take it out on the same day.

Compounding Interest Periods

Compounding periods are the time intervals between when interest is added to the account. Interest can be compounded annually, semi-annually, quarterly, monthly, daily, continuously, or on any other basis.

Interest on an account may be compounded daily but only received at the end of the month. Interest begins to earn additional interest once it has been credited, or added to the existing balance of interest. Standard compounding frequency schedules are usually applied to financial instruments:

• Savings accounts and money market accounts: The commonly used compounding schedule for savings accounts at banks is daily.
• Certificate of deposit (CD): It is common to have CD compounding frequencies to be on a daily or monthly basis.
• Series I bonds: Interest is compounded semi-annually; that means the interest is compounded and calculated two times a year.
• Loans: In many cases, interest is compounded every month, a fact that needs to be taken into account when borrowing. However, compounding interest may not be referred to by its name since it can be referred to by other names like ‘interest capitalization,’ as in the case of student loans.
• Credit cards: Card interest is often compounded daily, which can add up fast.

 Compound Interest: Start Saving Early

Young people often neglect to save for retirement. They may have other expenses they feel are more urgent with more time to save. Yet the earlier you start saving, the more compounding interest can work in your favor, even with relatively small amounts. Saving small amounts can pay off massively down the road—far more than saving higher amounts later in life. Here’s one example of its effect.

Let’s say you start saving $100 a month at age 20. You earn an average of 4% annually, compounded monthly across 40 years. You earn $151,550 by age 65. Your principal investment was just $54,100.

Your twin doesn’t begin investing until age 50. They invest $5,000 initially, then $500 monthly for 15 years, also averaging a monthly compounded 4% return. By age 65, your twin has only earned $132,147, with a principal investment of $95,000.

If your savings attain 45 years of coverage, your twin will have less, though the twin would contribute their money for about twice the amount you invested and for fifteen years only.

The same basic course of action works for obtaining an IRA and making the most of an employment-based retirement account such as a 401(k) or 403(b). It is recommended that one begin early and make consistent payments to maximize the power of compounding.

Advantages and disadvantages of compound interest in life insurance

– Advantages:

• Can help build wealth long-term in savings and investments: 

compound interest in life insurance is beneficial in investment and savings since the returns generate more returns.

• Mitigates wealth erosion risks: 

Another worth mentioning feature of compound interest is its effect of accelerating itself, which is also significant in combating factors that reduce wealth, such as cost of living, or eroding worthiness known as inflation.

• Compounding can work for you when making loan repayments: 

However, by paying more than the minimum balance, you can use compound interest to your advantage when settling the total interest.

– Disadvantages:

• Works against consumers making minimum payments on high-interest loans or credit card debts: 

This means if you only pay the minimum amount, the balance is likely to continue rising and soaring due to compounding interest. This is how people end up in a “debt cycle”.

• Returns are taxable:

 Interest income earned from compound interest in life insurance is taxed by the current tax rate provided the money is in a non-tax advantaged account.

• Challenging to calculate: 

Simpler interest is not complex to compute compared to compound interest which requires computation. The simplest way might be an online calculator.

Tip: Assets that have dividends, like dividend stocks or mutual funds, offer a one way for investors to take advantage of compound interest. Reinvested dividends are used to purchase more shares of the asset. Then, more interest can grow on a larger investment.

Compound Interest in Investing

An investor opting for a brokerage account’s dividend reinvestment plan (DRIP) is essentially using the power of compounding in their investments.

Investors can also get compounding interest with the purchase of a zero-coupon bond. Traditional bond issues provide investors with periodic interest payments based on the original terms of the bond issue. Because these payments are paid out in check form, the interest does not compound.

Zero-coupon bonds do not send interest checks to investors. Instead, this type of bond is purchased at a discount to its original value and grows over time. Zero-coupon-bond issuers use the power of compounding to increase the value of the bond so it reaches its full price at maturity.

The Bottom Line

The long-term effect of compound interest on savings and investments is indeed powerful. Because it grows your money much faster than simple interest, compound interest in life insurance is a central factor in increasing wealth. It also mitigates a rising cost of living caused by inflation.

For young people, compound interest offers a chance to take advantage of the time value of money. Remember when choosing your investments that the number of compounding periods is just as important as the interest rate.

FAQs

1- What Is a Simple Definition of compound interest in life insurance?

Compound interest simply means you’re earning interest on both your original saved money and any interest you earn on that original amount. Although the term “compound interest” includes the word interest, the concept applies beyond interest-bearing bank accounts and loans, including investments such as mutual funds.

2- Who Benefits From Compound Interest?

Compound interest benefits investors across the spectrum. Banks benefit from compound interest lending money and reinvesting interest received into additional loans. Depositors benefit from compound interest receiving interest on their bank accounts, bonds, or other investments.

References: 

• https://www.fidelity.com/learning-center/trading-investing/compound-interest
• https://www.prudential.com/financial-education/compound-interest-account
• https://www.insuranceandestates.com/compound-interest-growth/