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Interest-on-interest is a term that is used to identify the returns that are generated by taking the interest payments received on one investment and using the amount of those payments to purchase 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 realized from one bond to purchase the next bond in the sequence. Interest-on-interest can also be employed when it comes to the purchase of multiple loans, using the interest earned on one loan to purchase another one that hopefully provides even more interest income.
One of the easiest ways to understand the concept of interest-on-interest is to consider the purchase of a bond issue that results in a steady stream of interest payments over the life of that bond. Rather than using those interest payments for other purposes, the investor allocates those funds to the purchase of yet another bond. The end result is that even as the investor is continuing to receive interest payments on the first bond, a new stream of interest payment is realized with the second bond. The sequence can continue with the addition of more bonds to the string, with the purchases never requiring the investor to utilize anything other than interest income to buy the issues.
One of the benefits of an interest-on-interest approach is that the investors is able to constantly maintain a flow of interest income from several sources. By timing the issuance of those interest payments so they occur at different times of the year, it is possible to create a revenue stream that can be used either to purchase more bonds to perpetuate the process, or even use the income generated from the existing string of bonds for living expenses or other needs. Since bonds tend to carry a low level of volatility, the chances of beginning to lose money on this approach is limited.
There are some risks with using an interest-on-interest approach to create an ongoing revenue stream. If some of the bonds are structured with variable interest rates and the average rate should plummet, that could have an adverse effect on the integrity of the entire scheme. In addition, should 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 the interest income from a previous bond issue will help to minimize the chances of some adverse set of circumstances undermining the returns from this type of investment effort.