Making sure your money works for you is one of the best things you can do for it. Investing early allows you to build a significant nest egg over the years.
Compound interest plays a huge role in anyone’s financial security because it is almost always the key to success.
Finding the best compound interest investments according to your goals, timeline, and risk tolerance can be one of the most important steps toward reaching your financial goals.
If you’re wondering what investments have compound interest, below are some of the best investments available today.
We’ll teach you how to calculate compound interest, what investment accounts to consider, and how growth and capital gains can impact your long-term wealth over time.
What is Compound Interest?
Compound interest is the process of earning accrued interest on your investments and reinvesting that interest into the investment.
Returning the accrued interest into the investment allows your money to grow accelerated. Essentially, you’re making money not only on your original investment but also on any previous earnings.
The compound interest you earn over time can dramatically affect your net worth.
You can focus on compounding interest in the short term, but you’ll likely earn more money in the long term. For example, most people’s retirement savings result from accumulated interest over many decades.
Calculating compound interest is straightforward. Here is a simplified example of a compound interest formula.
Imagine you invest $100 at a yearly interest rate of five percent. In the first year, you would earn $5 in interest, for a total of $105. You no longer earn interest in the second year on just $100. Now, you earn interest on $105.
As such, you make more than the $5 in interest you earned the year before. Now, your investment would grow to $110.25 – an increase of five percent over the previous year’s earnings.
The process continues each year, so your investment will grow exponentially over time if you have a positive rate of return.
The above is a quick example, but if you extrapolate it, you can imagine how much interest you can earn over 30-40 years when you invest thousands of dollars per year.
Compound interest works; the longer you let it work in your favor, the greater the future value.
The power of compound interest is one reason it’s essential to start saving for retirement as early as possible.
Even if you can’t afford to contribute sizable amounts of money each month, investing consistently over time will result in significantly more savings than waiting until later in life to get started.
What are the Best Compound Interest Investments?
These are some of the best investment options to maximize compound interest:
Certificates of deposit (CDs)
A savings account or CD should be the first thing you consider if you are a beginning investor and want to utilize compound interest immediately. A CD is an instrument issued by a bank that requires a minimum deposit and pays interest regularly.
Unless you pay an early withdrawal penalty, the money is tied up until the term of the CD reaches maturity. Still, it usually pays a higher interest rate than a regular savings account. The highest interest rates are generally found on CDs issued by online institutions and credit unions. Typically, CDs have terms ranging from three months to five years. The money you invested in a CD will become available to you once it matures. You can choose a shorter-term CD if you need the money sooner than if it sat in a checking account without earning interest.
High-yield savings accounts
Most high-yield savings accounts do not require a minimum balance (or have a low balance requirement) and offer higher interest rates.
Money sitting in a non-interest-bearing account is lost due to rising interest rates and inflation. The main advantage of a high-yield savings account is that you earn interest while still having safety and FDIC insurance (up to $250k per account). You might have to maintain a minimum balance for an advertised interest rate, unlike most traditional savings accounts. To avoid disappointment, you should choose an account within your comfortable limitations.
Inflation will make it difficult for CDs and high-yield savings accounts to keep paying higher interest rates than traditional savings accounts. Investors need to consider more aggressive options to stay ahead of surging prices.
Bonds and bond funds
In general, bonds are considered good investments because they compound over time. The loans are given to a creditor, whether a company or the government. The entity or company agrees to provide a specific yield in exchange for the investor buying the debt.
To compound interest on a bond, you must reinvest the interest paid. Compound interest can also be achieved with bond funds, but the interest needs to be reinvested automatically.
There will be different levels of risk associated with bonds. Investing in long-term corporate bonds is riskier, but they offer higher yields. In contrast, U.S. Treasury securities are considered among the safest investments since they are backed by the full faith and credit of the United States.
Bonds can benefit investors who want to hold the investment for a long time but can be riskier than CDs and high-yield savings accounts. It’s because bonds’ prices can fluctuate over time. The prices of existing fixed-rate bonds can decrease as the prevailing interest rate increases. Conversely, if rates fall, bond prices will rise. Regardless of what happens in the interim, investors will receive their face value when the bond matures.
Money market accounts
An interest-bearing money market account is similar to a savings account. You can easily access your assets while earning a little higher interest than you would in a regular savings account. The advantage of money market accounts over high-yield savings accounts and CDs is that they usually allow check writing and debit cards, which are not available with high-yield savings accounts.
Investments that can compound your money a little faster
Investing in high-return investments and reinvesting the profits are two ways investors can take advantage of compounding today’s low-interest rates.
Investing in dividend stocks is even better than long-term equities on their own for compounding growth. The underlying asset of dividend stocks can continue to increase in value while making dividend payments, and the payouts can be reinvested to earn compound growth.
The Dividend Aristocrats are a group of S&P 500 companies that have increased dividends annually for at least 25 consecutive years. Consider these stocks if you’re looking for dividend income. IBM, Walmart, and Coca-Cola are among the companies on this list. Dividend stocks and dividend aristocrats are good investments for first-time investors looking to outpace inflation and compound income over the long term.
It’s important to remember that these companies tend to be less volatile and more stable, so they may not offer as much potential for outsized returns.
Real estate investment trusts (REITs)
Investing in real estate through REITs allows you to diversify your portfolio without buying the properties outright. Each year, REITs pay their shareholders at least 90 percent of their taxable income as dividends. Investors must reinvest their dividends to reap the benefits of compounding over time.
Investors need to understand that REIT investments are quite different from savings accounts and certificates of deposit. REIT prices can fluctuate over time, unlike very safe bank products. Interest rate fluctuations affect the real estate market disproportionately compared to other assets, affecting REITs.
Can Compound Interest Make You Rich?
The answer to this question is yes. Compound interest can make you rich, but there are a few things you need to do to achieve this.
First, you need to start investing as early as possible, so the effects of compounding have more time to work in your favor. Investing in your 20s and 30s is an excellent idea and a decision that can seriously pay off down the road.
Remember, you don’t have to invest a lot to get started. Every little bit counts.
Secondly, invest your money in investment vehicles that offer high returns, such as stocks and mutual funds. Investing like this can also help create passive income, especially if you earn dividend payments.
Take the time to learn about various funds and your options before choosing them. The more knowledge you have, the better.
Finally, resist the temptation to spend all of your hard-earned money. Budget, plan, save and invest regularly. Please pay attention to your money and track it as it grows through compounding.
If you can do these things over time, you will likely see your wealth grow, which will help you eventually reach financial freedom.
While it takes time to become wealthy through compound interest investments, it is possible with enough time and patience.
The return on less-risky compound interest investments, such as CDs and savings accounts, will be lower. Dividend stocks such as REITs and dividend REITs can provide a higher return with reinvested dividends but will require a higher level of risk tolerance. It is important to remember that compounding cannot occur efficiently without a long time horizon.