For the beginning investor hoping to establish a lifelong practice of saving and investing, understanding the significance of reinvested income will help you build wealth throughout your life. Over the long term, you may find that interest on your investments earns more than the original principal if you continually reinvest income and the power of compounding comes into play. In the United States, several types of investment products permit the investor to reinvest interest and earnings.
Mutual Fund Income
Reinvested income refers basically to taking earnings from your investments and using them to purchase additional investment products. For instance, many mutual funds permit investors to reinvest income earned from the assets in the fund. Let‘s suppose you own shares in a mutual fund that holds stocks of large cap companies as the underlying assets. When these companies pay dividends to the mutual fund, the earnings are passed along to investors who own shares in the mutual fund. If you choose to reinvest the income, you can use the proceeds to purchase additional shares in the fund, growing your position over time.
Some public companies in the United States offer shareholders a program known as a dividend reinvestment plan, commonly called by the acronym DRIP. When the shareholder enrolls in the DRIP, earnings from dividend payouts are automatically reinvested in more shares of stock. In addition, many brokers will reinvest income from your stocks for you. The firm may charge you a commission or fee for completing the transaction; this will cut into and deplete your total earnings.
Most all corporate, municipal and government bonds pay interest periodically. Bond investors may reinvest the income earned by purchasing more bonds. In the case of mutual funds or exchange-traded funds that hold bonds as the underlying assets, investors can often reinvest the income earned by purchasing additional shares in the bond-based products.
Power of Compounding
The power of compounding takes into account the original principal invested along with accrued interest. For example, if you invest $1,000 into a one-year certificate of deposit that draws 4 percent interest annually, after year one you would have earned $40. If you reinvest the income earned into a new one-year CD, along with the original principal, at the end of the second year, your investment would earn an additional $41.60 for a total value of $1,081.60. Continually reinvesting income earned over time takes advantage of the power of compounding and can result in the reinvested income earning as much or more interest than the original principal in the long term.
- Finance: Investments, Institutions, Management; Stanley G. Eakins; 2005
- FINRA: Investor Information -- Smart Bond Investing
- Investment Company Institute: How Mutual Funds and Investment Companies Operate
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