Compound Interest & Mutual Funds

Understanding compound interest in mutual funds and its importance

Compound interest benefits you to reach your financial goals, but what's the difference between simple and compound interest?

Simple interest is calculated on the principal, or original, amount of a loan.

Compound interest is calculated on the principal amount and the accumulated interest of previous periods, and thus can be regarded as “interest on interest.”

Mutual funds are popular vehicles that pool together money collected from investors. This capital is then invested in securities and assets—stocks, bonds, cash, money market vehicles, and others—based on the fund's profile, whether that's a small-cap fund, an international fund, a government bond fund, and so on. Investors, in return, earn income on their investments.

But do these vehicles pay interest? Of course, they do. And what's more, they offer one of the easiest ways for investors to reap the benefits of compound interest. Keep reading to find out how you can earn income from your mutual fund investments and how compound interest is linked to these financial vehicles.

Key Takeaways

Compound interest is calculated on the principal amount, plus any additional deposits and interest. Mutual funds offer one of the easiest ways for investors to reap the benefits of compound interest.

The more money you invest and the longer it sits, the more compound interest you'll earn. Reinvesting dividends and distributions also better your chances of earning more compound interest.

The Bottom Line

Compound interest is one of the simplest and most useful concepts in finance. But you don't have to be rich or a trading whiz for it to work in your investment objectives. You merely have to understand the time value of money and start investing as soon as possible.

The principle works the same whether you invest $10 or $10 million. By adding the interest earned back into the original capital investment, the mutual fund's value grows at an increasing rate.