You’ve heard about it often enough, most likely when choosing a 401(k) investment, but compound interest is perhaps the smartest investment strategy one can take regardless of what they actually invest in. The name of the game with compound interest is time, and the more of it you have, the bigger the payoff. That means if you’re a short-term investor, or looking to stay mostly liquid, then this strategy is most likely not best suited for you.
What is compound interest?
Compound interest is the interest you earn on interest. In short, you make an initial investment and receive a particular rate of return your first year which then multiplies year over year depending on the interest rate received.
Let’s say you make a $100 investment and receive a 7 percent rate of return in your first year. The interest has not yet compounded as you are in the beginning stage of the investment.
But then, during the second year you net another 7 percent return on that same investment. This means your original $100 grows as follows:
Year 1: $100 x 1.07 = $107
Year 2: $107 x 1.07 = $114.49
The $0.49 is compounded interest earned from the first to second year, as it is interest earned on top of the initial $7 in interest earned after the first year. The $7 gained in year one is simple interest. After this initial simple interest is gained, that’s when the interest starts earning interest which is what is defined as “compound interest.”
This might not seem like a lot, but compound interest truly takes off in long-term investment accounts.
For the sake of the example, let’s assume an account with a balance of $20,000 and an average return of 7 percent (10 percent is about the historical average return for the S&P 500 since its inception, and 7 percent can be thought of as relatively conservative.)
Year 1: $20,000 x 1.07 = $21,400
Year 2: $21,400 x 1.07 = $22,898
In two years, you will have gained almost $3,000 with $98 compound interest — simply by keeping it invested.
Using the Rule of 72 to estimate when your money will double
Over the course of a lifetime, you can double, triple, or “to the moon” your investment. An easy tool to estimate this is the Rule of 72, which is a calculation that estimates the number of years it takes to double your money at a specific rate of return. The calculation divides 72 by the rate of assumed return in order to estimate how many years it will take to double your investment.
In our above example, assuming a 7 percent return, you can calculate that 72 / 7 = 10.28, so it will take around 10 years to double your investment.
To maximize this strategy, it’s important to keep in mind that consistency — and nerve — are key. The rate of return is an average assumed over decades, which means a winning strategy will see several economic troughs and peaks investors will need to weather.
Best compound interest investments
To take advantage of the magic of compound interest, here are some of the best investments:
Certificates of deposit (CDs)
If you’re a beginning investor and want to start taking advantage of compound interest right away with as little risk as possible, savings vehicles such as CDs and savings accounts are the way to go. CDs are instruments issued by banks that require a minimum deposit and pay you interest at regular intervals.
The money is tied up until the term of the CD reaches maturity, unless you pay an early withdrawal penalty, but will typically pay a higher interest rate than a regular savings account. CDs from online institutions and credit unions tend to pay the highest rates. The term of a CD varies, most often ranging from three months to five years. Once the CD matures, you will have full access to your money. If you need the money sooner, you can select a shorter-term CD to give you a little more interest than if it was just sitting in a checking account.
High-yield savings accounts
High-yield savings accounts usually require no minimum balance (or a very low one) and pay a higher rate of interest than a typical savings account.
With increasing interest rates and inflation, money sitting in a non-interest-bearing account is money lost. One of the primary advantages to high-yield savings accounts is that you accrue interest while still having the safety and FDIC insurance (up to $250,000 per account) of a traditional savings account. Unlike most traditional savings accounts, though, you might need to maintain certain minimum balances in order to receive the advertised interest rate. So you will need to make sure you are selecting an account within limitations you’re comfortable with.
While both CDs and high-yield savings accounts will typically pay more than having your money sit in a traditional savings account, they will have a hard time keeping up with inflation. In order to stay ahead of surging prices, an investor would likely need to consider more aggressive options.
Bonds and bond funds
Bonds are usually seen as a good compounding investment. They are essentially loans one gives to a creditor, whether that’s a company or government entity. That entity or company then agrees to give a specified yield in return for the investor buying the debt.
Keep in mind that you will need to reinvest the interest paid on a bond in order to compound the interest. Bond funds can achieve compound interest, too, but would need to be set to automatically reinvest the interest.
Bonds will have varying levels of risk. Long-term corporate bonds are riskier but offer higher yields, whereas U.S. Treasury securities are considered to be among the safest investments you can make, as they are backed by the full faith and credit of the U.S. government.
Bonds can be beneficial to an investor who wants to hold the investment 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 lifetime. As prevailing interest rates increase, existing fixed-rate bonds can decrease in price. On the other hand, if rates fall, the price of the bond will rise. Regardless of what happens in the interim, when the bond matures, it will return its face value to investors.
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 rates of interest than a traditional savings account, money market accounts often allow for check writing and debit card privileges. These allow for ease of accessing your assets while earning a little higher interest than you would in a regular savings account.
Investments that can compound your money a little faster
With today’s low interest rates, it is generally difficult to compound with interest-only investments, but investors can also take advantage of compounding by investing in high-return investments and reinvesting the profits.
While long-term equities on their own are also a good investment to compound growth, dividend stocks are even better. Dividend stocks are a one-two punch, as the underlying asset can keep increasing in value while paying out dividends and this investment can earn compound growth if the payouts are reinvested.
If you’re looking for dividend income, you may want to look to the group of stocks known as the “Dividend Aristocrats.” This group of S&P 500 companies have increased dividends per share for at least 25 consecutive years. Some companies on this list include Coca-Cola, Walmart and IBM. So, for a first-time investor looking to potentially outpace inflation while compounding income long-term, dividend stocks and dividend aristocrats are a good way to go.
Keep in mind, these companies also tend to be more stable and less volatile, so they may not offer as much potential for outsized returns like the top growth stocks would.
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 out at least 90 percent of their taxable income to their shareholders in the form of dividends each year. As they do with other dividend stocks, investors must reinvest their payouts in order to enjoy the benefits of compounding over time.
REIT investors will need to be aware that these investments are quite different from a savings account or a CD. REITs are sensitive to fluctuations in interest rates, which affect the real estate market disproportionately compared to other assets. And unlike very safe bank products, the price of REITs can move up and down a lot over time.
Less-risky compound interest investments like CDs and savings accounts will be safer options but are more likely to net you a lower return. Choices like REITs and dividend stocks can net you a higher return with reinvested dividends but will require a higher risk tolerance to ride out the ups and downs of the stock market. The most important thing to remember is that compounding will not take place efficiently without a long time horizon.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.