In most cases, you will find that a bond will pay interest on a semi-annual basis. Those who have invested in a bond will be able to withdraw the interest if they choose, or they could reinvest it.
They may decide to reinvest in the same bond if it seems to be performing well, or they may invest in other bonds. Keep in mind that the interest on the reinvested amount can vary if another bond was purchased.
The term compounding refers to the interest that’s added to the principle, as well as the interest earned on received and reinvested interest. This has the potential to make the investment grow at a much faster pace than you would receive through keeping money in a savings account where the interest is typically so small.
Three factors affect the compounding rate. These include the nominal annual interest rate, the frequency of reinvesting interest payments, and the period of interest. If the nominal interest rate is high, it typically means that the compounding rate will be higher as well. Also, the longer the investment period, the higher the compounding rate.
What Is the Formula for Calculating Compounding?
To determine the compound interest, you will take the Future Value of Principal and Interest less Present Value of Principal. You can use the following formula.
Compounding Value = [P (1 + i)n] – P
In this case “P” is the Present Value of Principal, “i” is the nominal annual interest rate in percentage terms, and “n” is the number of compounding periods.
When the number of compounding periods is greater than once a year, you will need to adjust the “i” and the “n” as needed.
You will divide the “i” by the number of compounding periods in the year, and “n” will be the number of compounding periods.
Here is an example:
Let’s say that your investment in bonds has shown great potential to help you grow capital thanks to the semiannual coupon payments that will let you reinvest your interest two times each year.
The return of the investment is $10,000 with 5% compounded annually for 20 years would be lower than if the investment were compounded semiannually for the same period.
The amount of compound interest on $100,000 compounded semi-annually at 5% (i = 2.5%) for 20 years (n = 40) would be = $268,506.38-100,000 = $168,506.38. Total return for the period is 168.51%.
The amount of compound interest on $100,000 compounded annually at 5% (i = 5%) for 20 years (n = 20) would be = $265,329.77 – $100,000 =$165,329.77. Total return for the period is 165.33%.
The amount of accrued nominal interest on $100,000 paid annually at 5% for 20 years would be only = $200,000 – $100,000 = $10,000. Total return for the period is 100%.
The IncomeClub Solution
When you use compounding, it has the potential to increase your return over the long term.
If you are investing $100,000 and earning 5% interest and withdrawing it, the return would only be $100,000 in 20 years.
However, if you were to invest in a bond portfolio with the same amount, earning 2.5% semiannually and then reinvesting two times per year, you would receive $168,506.38 (168.51%) in the same amount of time.
With IncomeClub, you will have a number of auto-investing tools at your disposal, which can make it much easier to reinvest the interest quickly and simply.