DEFINITION of 'Automatic Reinvestment Plan'

An automatic reinvestment plan is a mutual fund plan that automatically reinvests capital gains back into the fund. In the case of a mutual fund, for example, capital gains produced by the fund would be used to automatically purchase more shares instead of being distributed to the investor as cash.

BREAKING DOWN 'Automatic Reinvestment Plan'

An automatic reinvestment plan helps an investor take advantage of the compounding effect to produce further gains. Over a period of years, the added value produced by automatic reinvestment can turn out to be worth a substantial sum.

Compound Interest in an Automatic Reinvestment Plan

Compound interest (or compounding interest) is interest calculated on the initial principal and on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.

Compound interest is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods minus one. The total initial amount of the loan is then subtracted from the resulting value.

Opting to reinvest a mutual fund's gains results in purchasing more shares of the fund. 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.

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 to an investment 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.

How Automatic Reinvestment Plans Affect Reinvestment

Automatic reinvestment plans are a great way to take advantage of compound interest. But taking the dividends and reinvesting in other parts of an investment portfolio can help increase diversification, since reinvesting the dividend back into the same mutual funds means that you're keeping a growing pile of eggs in the same basket. It may be prudent to use the dividends to create secondary safe harbor investments. Reinvesting dividends elsewhere can also be part of a rebalancing strategy.

RELATED TERMS
  1. Reinvestment Risk

    Reinvestment risk is the probability that an investor will be ...
  2. Reinvestment Rate

    The reinvestment rate is the amount of interest that can be earned ...
  3. Compounding

    Compounding is the process in which an asset's earnings, from ...
  4. Compound

    Compound is the ability of an asset to generate earnings, which ...
  5. Continuous Compounding

    Continuous compounding is the process of calculating interest ...
  6. Periodic Interest Rate

    The periodic interest rate is the interest rate charged on a ...
Related Articles
  1. Retirement

    Should retirees reinvest their dividends?

    Find out why dividend reinvestment may or may not be the right choice for retirees, depending on their financial needs in retirement and investment goals.
  2. Investing

    How Dividend Reinvestment Grows Your Money Faster

    Dividend reinvestment is a smart strategy for growing your investments faster over the long term, but it’s not a get-rich-quick proposition.
  3. Investing

    Continuous compound interest

    Different frequency in compound interest results in different returns. Check out how continuous compounding accelerates your return.
  4. Investing

    Overcoming Compounding's Dark Side

    Understanding how money is made and lost over time can help you improve your returns.
  5. Investing

    Investing $100 a month in stocks for 30 years

    Find out how you could potentially earn hundreds of thousands of dollars just by investing $100 a month in stocks during your working years.
  6. IPF - Banking

    APR and APY: Why Your Bank Hopes You Can't Tell The Difference

    Do you know the difference between Annual Percentage Rate and Annual Percentage Yield? Check out how they can affect your own account balance.
  7. Investing

    The Effective Annual Interest Rate

    The effective annual interest rate is a way of restating the annual interest rate so that it takes into account the effects of compounding.
  8. Investing

    4 Ways Simple Interest Is Used In Real Life

    Simple interest works in your favor when you're a borrower, but against you when you're an investor.
RELATED FAQS
  1. Should mutual fund dividends be reinvested?

    Learn the advantages and disadvantages, as well as the tax impact, of having your mutual fund dividends automatically reinvested ... Read Answer >>
  2. Which option is better on a mutual fund: a growth option or a dividend reinvestment ...

    One of the most confusing decisions when picking a mutual fund is the choice between a fund with a growth option or one with ... Read Answer >>
Trading Center