Tuesday, May 6, 2008

* What's More Powerful Than Compound Interest?

Compound interest is what occurs when interest previously earned is added to the principle and is considered when calculating future interest - i.e. earning interest on interest. I remember the elation as a small child when I first grasped the concept of compound interest (ok, so I lived a deprived childhood, but it has been financially rewarding). With a constant interest rate your earnings spiral up each and every year. Consider a $100 deposit earning 5%, compounded annually. In the first year you will earn $5, $5.25 in year 2, $5.51 in year 3, $5.79 in year 4, $6.08 in year 5, and so on.

So, back to the title question. What's more powerful than compound interest, faster than an tax audit and able to leap a 1099* in a single bound? Compound Dividends!

Compound dividends are like compound interest on steroids, simile speaking, of course. Let's continue the above example and assume that instead of depositing money in an interest-bearing account, you instead purchase good dividend stock with a current yield of 5%. So, in the first year you will earn $5. Which is the same as the 5% interest-bearing account, but that is where the similarities end. Good dividend stocks increase their dividends each year. In this example, let's assume a 10% dividend growth rate. So you will earn $5.78 in year 2, $6.71 in year 3, $7.81 in year 4, $9.17 in year 5, and so on.

Comparing the above two scenarios over the 5-year period, you will earn $27.63 from the interest-bearing account as compared to $37.47 from the dividend stock. That is more than a 35% increase!

Can life get any better than this? Yes it can! Good dividend stocks' yield tends to stay within a given range, so if dividends are increasing each year, the only way to keep a consistent yield is for the price of the stock to go up. In order to have a 5% yield in our above example at the end of year 5, the stock would have to be worth $183.44 (9.17/183.44 = 5%).

Dividend compounding, it doesn't get much better than that!

* A 1099 is the U.S. tax form used to report non-wage income from things such as interest, dividends and miscellaneous earnings.

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