You’ve heard about it plenty of times, probably when choosing a 401(k) investment, but compound interest can multiply your money. The name of the game with compound interest is time, and the more of it you have, the bigger the payout. That means if you are a short-term investor or want to remain mostly liquid, this strategy is probably not best suited for you.
What is compound interest?
Compound interest is the interest you receive on the interest. Basically, you make an initial investment and receive a certain return in the first year, which then multiplies year after year depending on the interest received.
Suppose you make a $100 investment and receive a 7 percent return in your first year. The interest has not yet accrued because you are in the initial phase of the investment.
But then you get another 7 percent return on that same investment in the second year. This means that your original €100 will grow as follows:
Year 1: $100 x 1.07 = $107
Year 2: $107 x 1.07 = $114.49
The $0.49 is compound interest earned between the first and second years, as it is interest earned on top of the initial $7 of interest earned after the first year. The $7 you earned in the first year is simple interest. After this initial simple interest, the interest begins to earn interest, which is defined as “compound interest.”
This may not seem like much, but compound interest is really taking off in long-term investment accounts.
For the sake of example, let’s assume an account with a balance of $20,000 and an average return of 7 percent (10 percent is approximately the historical average return for the S&P 500 since its inception, and 7 percent can be seen as relatively conservative considered.)
Year 1: $20,000 x 1.07 = $21,400
Year 2: $21,400 x 1.07 = $22,898
In two years, you will have earned almost $2,900 with compound interest of $98 just by keeping it invested.
Use the Rule of 72 to estimate when your money will double
Over the course of your lifetime, you can double, triple, or ‘go to the moon’ with your investment. A simple tool to estimate your growth is the Rule of 72, which estimates the number of years it will take to double your money at a given rate of return. The calculation divides 72 by the assumed rate of return to estimate how many years it will take to double your investment.
In our example above, assuming a 7 percent return, you can calculate that 72/7 = 10.28, so it will take about 10 years to double your investment.
To maximize this strategy, it’s important to keep in mind that consistency – and grit – are key. Returns are an average assumed over decades, meaning a winning strategy will have several economic lows and highs, and investors will have to weather them.
Best Compound Interest Investments
To take advantage of the magic of compound interest, here are some of the best investments:
1. Certificates of Deposit (CDs)
If you are a novice investor and want to benefit from compound interest immediately and with as little risk as possible, savings options such as CDs and savings accounts are the right choice. CDs require a minimum deposit and pay you interest at regular intervals, usually at a higher rate than a regular savings account.
The term of a CD can vary, usually ranging from three months to five years. Once the CD matures, you have full access to your money. If you need the money sooner, you can select a CD with a shorter term to give you a little more interest than if the money were simply sitting in a checking account, or you can pay an early withdrawal penalty. CDs from online institutions and credit unions typically pay the highest rates.
2. Savings accounts with high returns
High-yield savings accounts typically require no minimum balance (or a very low balance) and pay a higher interest rate than a typical savings account.
With rising interest rates and inflation, money sitting in a non-interest bearing account is money lost. One of the main benefits of high-yield savings accounts is that you accrue interest while still having the security and FDIC insurance (up to $250,000 per account) of a traditional savings account. Unlike most traditional savings accounts, you may be required to maintain certain minimum balances to receive the advertised interest rate. So you should make sure you select an account with restrictions you are comfortable with.
While both CDs and high-yield savings accounts typically earn more than keeping your money in a traditional savings account, they will have a hard time keeping up with inflation. To stay ahead of rising prices, an investor will likely need more aggressive options.
3. Bonds and bond funds
Bonds are generally seen as a good composite investment. They are essentially loans given to a creditor, be it a company or a government. That entity then agrees to provide a certain return in exchange for the investor purchasing the debt.
Keep in mind that you must reinvest the interest paid on a bond in order to compound the interest. Bond funds can also realize compound interest and can be set to automatically reinvest the interest.
Bonds have different levels of risk. Long-term corporate bonds are riskier but offer higher returns, while US Treasury bonds are considered one of the safest investments you can make because they are backed by the full faith and credit of the US government.
Bonds can be beneficial for an investor who wants to hold the investment for the long term, but can be riskier compared to CDs and high-yield savings accounts. That’s because the price of bonds can fluctuate during their lives. As prevailing interest rates rise, existing fixed-rate bonds may decline in price. On the other hand, if interest rates fall, the price of the bond will rise. Regardless of what happens in the meantime, when the bond matures, it will return its face value to investors.
4. Money Market Accounts
Money market accounts are interest-bearing accounts, similar to savings accounts. Unlike high-yield savings accounts and CDs, which also pay higher interest rates than a traditional savings account, money market accounts often offer the ability to write checks and use debit card privileges. These ensure that you have easy access to your assets while earning a slightly higher interest rate than on a regular savings account.
Investments that allow you to build up your money a little faster
With current interest rates, it is generally difficult to invest at a high interest rate with interest-only investments, but investors can also take advantage of compound interest by investing in high-yield investments and reinvesting the profits.
Dividend stocks
While stocks are a good investment for fueling growth, dividend stocks can be even better. Dividend stocks are a one-two punch because the underlying asset can continue to appreciate in value while paying dividends, and this investment can deliver compound growth if the payouts are reinvested.
If you’re looking for dividend income, you may want to look at the group of stocks known as the ‘Dividend Aristocrats’. This group of S&P 500 companies has increased dividends per share for at least 25 years in a row. Some companies on this list include Coca-Cola, Walmart, and IBM. So for a novice investor looking to potentially beat inflation while increasing long-term income, dividend stocks and Dividend Aristocrats are a good choice.
Keep in mind that these companies also tend to be more stable and less volatile, so they may not offer as much potential for outsized returns as the top growth stocks.
Real Estate Investment Trusts (REITs)
REITs are a great way to diversify your portfolio by investing in real estate without having to buy the property outright. REITs pay at least 90 percent of their taxable income to their shareholders each year in the form of dividends. As with other dividend stocks, investors must reinvest their payouts to reap the benefits of compounding over time.
REIT investors will need to be aware that these investments are very different from a savings account or a CD. REITs are sensitive to fluctuations in interest rates, which disproportionately affect the real estate market compared to other assets. And unlike high-security banking products, the price of REITs can move up and down a lot over time.
In short
Less risky investments with compound interest, such as CDs and savings accounts, are safer options, but will likely give you lower returns. Choices like REITs and dividend stocks can give you higher returns with reinvested dividends, but require a higher risk tolerance to weather the ups and downs of the stock market. The important thing to remember is that compounding will not happen without a long time horizon.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
