What Is the Link Between Mutual Funds and Compound 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 or dividends? Many 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.

Mutual Fund Returns

As mentioned above, mutual funds are attractive investments for investors who want to diversify their portfolios. Investors purchase shares in a mutual fund or funds that fit their financial goals, risk tolerance, and lifestyle. The money collected is then used by portfolio managers to invest in other assets, giving investors exposure to a range of different securities.

So one share of a large-cap fund gives investors a small degree of ownership in a variety of companies. Actively-managed funds are monitored regularly, with the fund manager reallocating assets so the fund meets its objectives.

There are several ways mutual funds pay returns to their investors. First, you can earn money from dividends of the securities that make up the fund holdings. The fund company normally pays income in the form of distributions. You can take these in cash or reinvest them.

Most funds also pass on capital gains to investors in a distribution. These gains stem from the sale of securities that increase in price. The last way you can earn a return from a mutual fund is by selling your shares for a profit. You'll realize a profit if prices for holdings rise but aren't sold by the manager.

Compound Interest Adds up Fast

So how does compound interest factor into mutual funds? Remember, compound interest is paid on the accrued interest you earn. Therefore, it is calculated on the principal amount plus any additional deposits and interest. You can also think of it as interest on interest. Compound interest allows your balance to grow faster than simple interest, which only takes the principal amount into account.

It's easy to increase your compound interest as a mutual fund investor. The more money you invest and the longer it sits, the more it grows. Choosing to reinvest your fund's dividends also better your chances of earning more compound interest. That's because you purchase more shares of the fund when you put the distributions back into it. More compound interest accumulates over time, and the cycle of purchasing more shares will continue to help the fund, and one's initial investment in it, grow faster in value.

What is Compound Interest?

Katie Kerpel {Copyright} Investopedia, 2019.

 

Reinvest your mutual fund distributions rather than taking them in cash if you want to earn more compound interest.

Example of Compound Interest

To better demonstrate how compound interest works with a mutual fund, here's a hypothetical example. Consider a mutual fund opened with an initial investment of $5,000 and subsequent ongoing annual additions of $2,400. With an average of 12% annual return over 30 years, the future value of the fund is $798,500.

The compound interest is the difference between the cash contributed and the actual future value of the investment. In this case, by contributing $77,000—or a cumulative contribution of just $200 per month over 30 years—compound interest comes to $721,500 of the future balance.

Are Mutual Fund Distributions Taxable?

Yes. If you hold mutual fund shares in a taxable account, distributions, whether paid out in cash or reinvested in additional shares, are taxable. These will be reported annually on IRS Form 1099-DIV.

How Can I Avoid Paying Taxes on Mutual Fund Distributions?

If you hold a mutual fund in a Roth IRA, both capital gains and distributions are not subject to income tax. Distributions and gains are tax-deferred in a traditional IRA or 401(k) plan.

What Is Simple Interest?

Compound interest pays returns on both the amount invested plus all previous returns. Simple interest, in contrast, only pays out on the invested amount each period. As a result, compounding allows investments to grow much more quickly over time than simple interest can.

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 favor. 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 $20 or $20 million. By adding the interest earned back into the original capital investment, the mutual fund's value grows at an increasing rate.

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