Interest on interest is the process of using interest payments from an investment to purchase other investments that generate more interest payments. This approach can create a continuous stream of income, but there are risks involved, such as variable interest rates and early bond calls.
Interest on interest is a term used to identify the returns that are generated by taking the interest payments received from an investment and using the amount of those payments to buy other investments that in turn generate more interest payments. The term is most often associated with the serial purchase of bond issues, using the proceeds earned from one bond to purchase the next bond in the sequence. Interest on interest can also be employed when it comes to purchasing multiple loans, using the interest earned on one loan to purchase another that hopefully provides even more interest income.
One of the easiest ways to understand the concept of interest on interest is to consider purchasing a bond issue that results in a steady stream of interest payments over the life of that bond. Instead of using those interest payments for other purposes, the investor allocates those funds to the purchase of another bond. The end result is that even as the investor continues to receive interest payments on the first bond, a new stream of interest payments is made on the second bond. The sequence can continue with more bonds being added to the chain, and the purchases never require the investor to use anything other than interest income to purchase the issues.
One of the benefits of an interest on interest approach is that investors can constantly maintain a stream of interest income from various sources. By timing the issuance of those interest payments to occur at different times of the year, it is possible to create a stream of income that can be used to buy more bonds to perpetuate the process, or even use the income generated by the existing chain of bonds. for living expenses or other needs. Since bonds tend to have a low level of volatility, the chances of starting to lose money with this approach are limited.
There are some risks with using an interest on interest approach to create a continuous stream of income. If some of the bonds are structured with variable interest rates and the average rate plummets, that could have an adverse effect on the integrity of the entire scheme. Also, if issuers choose to call one or more of those bond issues before the maturity date, this could also derail the strategy. Taking the time to carefully select which bonds to buy with interest income from a previous bond issue will help minimize the chances that adverse circumstances will hurt returns from this type of investment effort.
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