Forward-thinking investors often hunt for smart and safe avenues to grow their funds. Being a strategic investor, you wouldn’t hesitate to consider compound interest as the ‘eighth wonder’.
Simply defined, compound interest is the interest that you accumulate on top of the interest and principal amount. Sounds confusing? Don’t fret! 69% of Americans don’t understand how compound interest works. Eventually, they miss out on lucrative investment avenues.
Investing in accounts yielding compound interest can be your life hack for unlimited money! Let’s understand the impact of compounding interest, how compound interest works, and the best investment avenues to realize the power of compound interest.
What is compound interest?
Compound interest is the interest that a financial organization or bank pays on both your initial deposit and the interest accumulated on it. That’s why it’s defined as the interest on interest as well as the capital deposit. Banks and other financial institutions compound interest on different schedules or frequencies, such as annually, monthly, or even daily. The compounded interest would be greater for longer compounding periods.
Suppose you deposit $2000 for two years on a simple-interest-earning account at an interest rate of 6%. The total interest for two years would be $240 ($120 in each year).
At the same time, let’s say you invested $2000 in a compound-interest-bearing account that compounds annually at 6% p.a. In this case, you’ll earn an interest of $120 for the first year (same as in the case of a simple interest account). However, for the second year, you’ll earn interest on a total sum of $2120, which amounts to $127.2.
In the case of simple interest, your initial principal is considered a constant base for calculating the interest for every year on a lateral basis. However, in the case of compound interest, the principal each year increases by the amount of cumulative interest earned in the previous years.
In the example above, the extra $7.2 is earned on the interest amount of the first year, i.e.$120. This may sound like an insignificant amount for now. However, a sum of $2000 at 6% compounded annually will double itself in approximately 12 years. In contrast, a simple interest account will take 16.5 years to do the same.
What makes compound interest so crucial for wealth building?
As an investor, it pays to develop a balanced portfolio by including funds that yield compound investments. Accumulating interest on a compounded basis makes the gains over your interest even more profitable. With compound interest, you can bolster your wealth portfolio as the money accumulates faster.
Suppose you have a quarterly compounding period. So, you continue accumulating interest four times a year, compared to just once in the case of simple interest.
Reaching your financial goals can be much more practical when you vouch for the compound growth of your investments. Considering the faster growth potential with compound interest, you need not block or allocate as many funds as you need to do with annuities yielding simple interest.
The earlier you start investing in annuities with compound interest; the greater would be your wealth portfolio. One of the best perks of this compounding effect is its ability to counter inflation and increased living costs, which tend to erode your wealth. This explains why people saving for retirement go for annuities and bank accounts yielding compound interest rather than simple interest.
So, if you invest $10,000 at just 5% compound interest calculated annually for 30 years, it would acquire over $30,000 as compound interest, and your account would be worth more than $40,000.
How can investors use compound interest to their advantage?
As we mentioned, the faster you start investing in annuities or bank accounts yielding compound interest, the more you gain. However, where should you invest to develop a fast and safe growth portfolio? We have recommended some short and long-term accounts yielding compound interest that can streamline your wealth-building journey.
1. Your employer’s 401(k) plan
Investors can explore several retirement savings accounts offering tax advantages to benefit from the compounding effect. These plans are typically long-term accounts, given that you would be saving for retirement. A traditional IRA or Roth IRA would be suitable for you.
Once you channel your funds to a 401(k), the amount gets diversified in different bonds and mutual funds. Over time, these funds keep growing through compounding. Now, the interest on your 401(k) compounds according to the nature of the investments. The frequency can be annually, quarterly, or monthly.
To maximize the power of compounding, reinvest the amount monthly or go for a monthly compounding plan rather than an annual one. The more frequently it’s compounded, the greater your returns will be.
2. CDs (Certificates of deposits)
CDs continue to be one of the best instruments to yield compound interest for young adults. If you are just getting started with investments or planning to build your wealth, it pays to go for CDs. These investments are risk-free and are insured up to $250,000 in the US. Just like your savings account, you can park funds in CDs if you are ready to commit yourself to long-term investments. CDs yield compound interest, and you can choose a tenure between three months and five years.
Your deposited funds remain locked in the CD until it matures. However, withdrawing it in case of an emergency before the maturity period requires you to shell out a penalty. The reason to open a CD rather than a savings account is that you can leverage the compounding power of interest.
Credit unions and online institutions offer CDs at higher interest rates. The longer the tenure, the greater would be your financial gains. The investor would get full access to the funds once the account matures. If you don’t want to commit yourself to a longer tenure, choose a shorter CD plan ranging from three to nine months. Evaluate your financial goals and put aside your emergency funds before opening a CD.
3. High-yield savings accounts
Another safe instrument to invest and yield compound interest is a high-yield savings account. Compared to an ordinary savings account, these investments generate greater interest. Usually, you need to maintain a meager minimum balance in these accounts to qualify for the mentioned interest rate.
Amidst inflation hitting the 6.2% mark in the US, any non-interest-bearing amount leads to fund erosion. Therefore, it’s logical to open a high-yield savings account rather than park your funds in a normal savings account.
Just like CDs, the account holder can enjoy FDIC insurance of $250,000 per account. So, at a time when US citizens are struggling to beat inflation, channeling your investments to a high-yield savings account would be a logical decision.
However, one of the drawbacks of these accounts is that the bank might alter the advertised interest rate based on market conditions. Considering economic downturns, it’s wise to find banks promising the best rates for these accounts.
High-yield savings accounts are ideal if you want to put aside funds for your property down payment or fund a vacation. In case you are planning to use the funds in less than five years, these investments would be good to go.
4. Bonds and bond funds
A part of your short-term investment portfolio should include bonds and bond funds. These investments generate compound interest. Bonds are loans that one gives to a government entity or a company serving as a creditor. As per the agreement, the company or entity gives a pre-decided yield as the investor purchases the debt.
Investors can also yield compound interest through bond funds. In this case, you need to auto-reinvest the earned interest.
Bonds come with different risk levels. If you are comfortable taking risks, go for long-term corporate bonds. However, if you want to play safe, go for U.S. Treasury securities, as the US government backs these investments with full faith.
Long-term investors planning to reap the power of compounding habitually invest in bonds. Compared to high-yield savings accounts and CDs, bonds can be riskier. The fluctuating nature of bond prices makes them slightly risky. When the existing interest rates increase, bonds with fixed rates diminish in price. Again, when interest rates drop, the value of bonds increases. Not considering what happens in between, investors receive the face value when it matures.
5. Money market account
If you are looking for a short-term investment avenue offering more liquidity and higher interest compared to a standard savings account, go for an MMA (money market account). With the cost of living increasing consistently, it’s logical to diversify your portfolio with MMA.
The positive aspect of MMA is that the account holder would be able to access it without paying any penalty in case any financial emergency arises. Opening an MMA account would serve your short-term financial goals.
However, one drawback of MMA is the lower rate of compounded interest compared to other investment instruments. So, your returns might not be as high as other instruments on this list.
Besides, most banks require the account holder to maintain a minimum balance to open and maintain the account throughout the tenure. You may have to fork out a fee if the minimum balance drops below the mentioned amount.
Account holders also get checkbooks with some MMAs. If you need money urgently, you can access funds quickly.
Alternative investment channels to enjoy compounded growth
Apart from the instruments we mentioned, you can also diversify your portfolio by investing in the following channels. However, these investment avenues won’t yield compound interest directly. Rather, you need to reinvest the payouts from time to time to enjoy the effect of compounding.
1. Exchanged traded funds (ETFs)
An exchange-traded fund (ETF) is an investment that tracks an index like the S&P 500. If the value of the index rises, your ETF will fetch you better returns. You can purchase or sell ETFs in the stock markets during trading hours. Currently, commission-free ETFs are also available with some brokerages.
It’s worth noting that ETFs don’t generate compound interest. However, you can enjoy compounded growth when the value of the fund’s assets rises or through dividends. Reinvesting the dividends into the ETF would yield a compounded profit for you.
Investors prefer ETFs as these investment instruments involve low costs. Some ETFs focus on particular segments of the economy, such as healthcare or technology. Other ETFs are based on specific demographic regions.
The fact that investors can instantly purchase and sell ETFs and offer fair diversification to your portfolio makes them a popular choice.
Well, if you are keen to invest in real estate without directly owning a property, go for real estate investment trusts (REITs). Each year, shareholders receive 90% of the REIT’s taxable income as dividends. Just like other dividend-yielding stocks, investors need to reinvest these dividends to benefit from the compounding effect.
Being an investor, it’s wise to know that REIT investments are different from CDs and savings accounts. These investments are more susceptible to market volatility, and the interest rates fluctuate. This makes real estate investments slightly risky.
3. Dividend-yielding stocks
Investing in stocks that yield dividends can be a great way to balance your investment portfolio. Investors generally purchase shares of companies likely to be on a growth trajectory. Over the years, the value of its stocks would keep increasing. Correspondingly, your asset value keeps rising.
Now, it’s wise to choose dividend-yielding stocks that would deliver you regular payouts in addition to the growth in stock value. It’s wise to reinvest these dividends automatically, which would grow your overall investment.
Investors should be wary of risks in the stock market, as company shares tend to be volatile. Amidst economic uncertainty, stocks wouldn’t be a good pick for short-term investments. However, if you decide to channel your investments, prioritizing your long-term financial goals, dividend-yielding stocks would be a viable option.
Safe investors generally stick to annuities, savings accounts, and CDs yielding compound interest. However, controlled aggression while balancing your investment portfolio makes your savings more resilient to inflation. This explains why investment advisors recommend balancing your portfolio by channeling a part of your funds to stocks and mutual funds.
Remember, you can capitalize on the compounding power of interest on a longer time horizon. With strategic planning and fund allocation, investors would love to capitalize on the power of compounding to the fullest.