For those who are living paycheck to paycheck, the thought of trying to build wealth or plan for retirement might feel strongly out of reach. It is certainly difficult to think about long-term financial goals when you are barely making ends meet, but the current high cost of living should not completely preclude you from investing in your future. Compound interest is a financial strategy worth exploring during inflationary times because it can actually provide an intelligent hedge against future periods of high inflation.

The Basics of Inflation

In macroeconomic terms, inflation is what happens when regional economies go through periods of lower purchasing power. The basic mechanism of inflation involves consumer prices going up while salaries stagnate or prove to be insufficient. There are various ways to measure inflation, but the one method that truly applies to everyday Americans is the consumer price Index (CPI), which in the U.S. is measured and published by the Bureau of Labor Statistics. The CPI has increased by nearly 9% since May 2021, which means that your paycheck feels at least 10% lighter compared to last year.

Microeconomics researchers at the University of Michigan believe that the real impact of inflation on American families is closer to 15%, particularly when we take into account fuel prices, mortgage interest rates, and the higher cost of rents. Americans are hardly the only ones dealing with inflation in 2022; in Argentina, for example, the CPI has increased by more than 60% on an annual basis.

The current economic trend of global inflation is tied to various geopolitical factors, such as the Russian invasion of Ukraine, the lower production output in China, and the slow pace of recovery from the pandemic. We feel these reverberations because we live in a globalized economy. With the very few exceptions of tiny nations that happen to enjoy considerable wealth, inflation has become a global issue that cannot be escaped, but this does not mean it cannot be mitigated.

In all economies driven by capitalism and free markets, the rate of inflation will always outpace the yield of compound interest; this is the result of financial competition, and it allows regulators to avoid the kind of severe inefficiencies that can spiral down into an economic depression.

If we take the 15% real CPI estimated by the University of Michigan, we see that it is much higher than the 5.5% rate of interest set by the U.S. Federal Reserve Board in August 2022. It is also much higher than the most enticing compound interest high-yield savings account, which offers a 2.25% annual percentage yield (APY). Even the most lucrative five-year certificate of deposit was only paying about 3.5% in August 2022.

In order for an American investor to defeat inflation in 2022, the annual return on an asset portfolio would have to be greater than 15%. We have already established that compound interest alone will not catch up to inflation. You might be able to accomplish this through stock investing or real estate, but those are investing activities that convey a certain amount of risk, and which are not guaranteed to produce returns.

Compound Interest and Inflation

We know that inflation reduces our purchasing power along with the value of our savings. Obviously, this is not an ideal situation for building wealth, which is why compounding is one of the best financial strategies to hedge against inflation. To see how compound interest can help you deal with inflation, let’s use one of our calculators to figure out the following scenario:

• In the year 2012, a nurse in Idaho deposited $1,000 into a money market account, paying 1% APY compounded on a daily basis. She also made a firm commitment to contribute $500 each month to the account.
• In 2022, the nurse will have $64,206 in her money market account. She has effectively grown her account balance into a safety net that can help her alleviate some of the negative effects of inflation. While her income may have lost 15% of purchasing power over the last 12 months or so, she could very well tap into her account in order to cover monetary shortfalls.

Time will always be the most important factor in the calculation of compound interest. If the nurse in the example above had not applied a compounding strategy ten years ago, her financial ability to deal with inflation today would be sharply diminished. Since we can’t really make up for the lost time, we must keep in mind that failing to build wealth now will affect us in the future. Now is the time to get started with compounding because the inflation we consider to be extraordinary now may become the new normal down the line. Any funds that you are able to deposit for compounding today might be the funds that save you from catastrophic financial ruin tomorrow.

All in all, if you decide to wait until inflation levels off to start compounding, you would be missing out on daily interest being paid and reinvested into your portfolio. We don’t know if things will ever get back to normal; arguably, wages would need to be raised at some point, but this may take longer than expected. Time is one of those things that we can’t get back once it is gone. The time to take advantage of compound interest will always be now. Waiting for things to get better does not make sense; you don’t want to lose out on the exponential nature of compound interest. The longer you wait, the less you will be able to earn.

Suppose you decide to take the alternate route and stick some money into a cryptocurrency staking account, many of which pay great rates between four and ten percent. Yes, there’s risk associated with putting capital into any cryptocurrency-related asset, but we’ll assume you decide to use a staking account for our hypothetical example.

Ethereum

For instance, Ethereum is one of the most stable, trusted, and capitalized of all the alt-coins out there, so we’ll use it for the interest-calculation scenario. Keep in mind that millions of investors and savers leverage the power of cryptocurrency staking accounts to earn solid interest rates. Some coins even offer bonuses to depositors after a fixed amount of time.

Private Bank Offers Compared

The following situation is based on an actual offer that a private bank offered to a business client. Amounts and percentages have been changed slightly to make the lesson more evident. Private Bank ABC offered a business owner the following deal:

“We have three different interest rates for our depositors who make monthly deposits into Ethereum staking accounts.

Because no one can guarantee what Ethereum’s value will be five years from now, now can they predict that Ethereum will continue to offer interest at five percent, our private bank, ABC, will take on some of the risk by guaranteeing our customers a flat rate of five percent on monthly deposits of $1,000 for a period of five years.

We have three bonus plateaus:

Plateau 1:

Deposits made in a timely manner, at the end of each month, for 60 months, earn 5.0 percent compounded interest and an end-of-period cash bonus of $500.

Plateau 2:

Plateau 2 is the same as plateau 1 with the following difference: there is an end-of-period cash bonus of $1,500, and the interest rate is 4.5 percent.

Plateau 3:

Our third plateau offers the lowest interest rate of all, 4.0 percent but the largest cash bonus, $2,000.

Our bank believes in giving depositors an option to receive the rate of interest and cash bonus combination that best suits their needs.”

Crunching the Numbers

Because ABC Bank offers three different interest rates as well as a three-tiered cash bonus arrangement, it’s not apparent which deal is the best for an investor. You decide to crunch the data using an interest-rate calculator.

Here’s how the math stacks up for each of the three plateaus.

Scenario One

With plateau 1, we get an end-of-period bonus of $500 for depositing $1,000 every month for five years at a 5.0 percent interest yield. Using the calculator noted above, that translates to $68,006.08 after the time is up. Add in the $500 cash bonus, and we have a total of $68,506.08 in our account.

Of the total, $8,006.08 represents interest, and $500 is bonus cash. Our deposits were $60,000 in all. That’s an excellent yield in these days of cheapskate banks, so ABC is offering a pretty good deal with plateau 1. Let’s see how the other two options stack up before deciding which one to accept.

Scenario Two

Plateau 2 offers a lower interest rate, 4.5 percent, but a higher cash bonus of $1,500.

It looks like ABC bank is rewarding depositors for taking a lower interest rate. Using the same calculator as we did in the last example, here is the data:

Of course, our total is lower because we accepted a full half-percent less in interest. We deposited $60,000 and earned $7,145.55 in interest. Add the cash bonus of $1,500 to the mix, and we end up with $68,645.55, which is just a bit better than plateau 1, but not by much. Let’s see how plateau 3 measures up.

Scenario Three

In plateau 3, the bank only offers us the interest of 4.0 percent, but the cash bonus is a substantial $2,000. Is the bonus enough to offset the lower interest rate? Let’s use the calculator to find out.

At 4.0 percent interest, our $60,000 in cash deposits grow to $66,298.98, of which $6,6298.98 is interest. Add in the $2,000 cash bonus, and we have $68,298.98 in the account after five years have passed. It looks like plateau 3 is the worst deal of all. Its low-interest-rate was enough to offset the highest cash bonus.

Results Tell the Story

How do the three plateaus compare? Here are the total account balances in each one at the end of the five years, after interest and cash bonuses have been added in:

Plateau 1:

The account holds $68,506

Plateau 2:

The account holds $68,645

Plateau 3:

The account holds $68,298

Analyzing the Choices

There are a couple of interesting facts to note about the results. First, plateau 2 was the best deal, but not by much. In fact, it only paid $139 more than plateau 1 and $347 more than plateau 3.

Second, remember that the bank guarantees the interest rates as well as the cash bonuses, which means investors are taking no risk. However, the bank stands to lose or gain a lot depending on how well Ethereum performs during the next five years. Suppose the coin shoots up in value. That would benefit the bank but have no effect on investors.

Likewise, if Ethereum declines in value and begins paying lower staking interest, the bank loses significantly, yet investors are shielded from the downturn.

In scenarios such as this, it’s important to run all the numbers and calculate the interest and any cash or other kinds of bonuses offered by banks or private investment organizations. Staking cryptocurrency can be a risky proposition, but if a bank chooses to take on all the risk and offer investors guaranteed interest rates as well as cash bonuses, investors should examine the whole picture before deciding how to proceed.

Interest is also applied when you’re borrowing money. This is how the bank or creditor will earn their money as you pay back the loan. When applying for the loan, you should avoid getting a loan with compounding interest since it means you’ll have to pay more on your loan with it. Just remember compounding interest can be lucrative for you if you’re investing, but it means you’ll pay more if you borrow with it.

Simple Interest Investment

To show you the difference between simple and compounded interest, you first need to know what both of them are. When you open an account that accrues simple interest, you can easily determine the interest you’ll earn with this simple interest formula: Interest = P x R x N. The principal amount is the initial amount you deposit into the account, and the letter P represents it. The letter R signifies the interest rate percentage in a decimal. Finally, the letter N is the time period. The time periods are usually expressed in months or years.

Consider this scenario, simple interest earned on a principal amount of $10,000 will be $100 with a 1% interest rate over a year. The formula with these values plugged in is Interest = 10,000 x 0.01 x 1. The amount of return is going to be $100. The interest rate is only applied to the initial principal amount deposited with simple interest. That interest rate stays with the loan, and you cannot earn more interest on the new total amount unless you compound the interest rate by reinvesting the already accrued interest.

Frequency of Compounding Interest

Interest can be compounded daily, monthly, quarterly, or yearly. As noted, it will take time for you to grow your wealth a substantial amount. The total amount of interest you’ll accumulate depends on how often the interest is compounded and the amount of time your money is in the account. It is not a system where you can get rich quickly, but a system where you can get rich easily as you don’t have to do anything. The interest accumulates without additional work from you as long as it stays in the account for a substantial time.

Compounding Interest Formula

Compound interest can also be calculated with a formula. That formula is A = P(1 + r/n) (nt). The formula only looks complicated, but it’s actually not that difficult since all you need to do is input your values into it. In this formula, the letter A signifies the total amount. We already know the representation of the letters P, R, and N. The letter t represents the amount of time the money is put into the account, usually expressed in years.

Compound Daily also has calculators available for you to use, including a compound interest calculator. You can simply input the values you’re looking to invest in and the interest rate offered. Then you’ll be able to determine how much money you can make with that investment offer. It’s also easier to compare multiple offers with this calculator. For example, you can input the values for one investment opportunity and the values of another opportunity to determine which is the better offer.

The formula for compound interest is A = P(1 + r/n)(nt). So, let’s say you want to invest $10,000 at a rate of 5% interest that is compounded daily for five years. You plug the numbers into the formula and get this 10,000(1 + 0.05/365)(365 * 5). Your answer is $12,840.03432147 or $12,840.03. That’s $2,840.03 in accumulated interest. If you had the same scenario but with simple interest, you would’ve only earned $2,500 and a total amount of $12,500.00. As you can see, by compounding the interest you earned, you can make over $300 more than with the simple interest and the same monetary amounts.

With compounding interest, you have the chance of earning more money in interest than with only investing with simple interest. However, you also should remember to only seek compounding interest with investments. For example, when you take out a loan and have compounding interest, you’ll be paying more than you would be with a simple interest loan. Compound Daily is here for you when you’re deciding which loan or investment opportunity is right for you.