Best Compound Interest Investments | Bankrate

You’ve heard of 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 you’re actually investing in. The name of the game with compound interest is time, and the more you have, the greater the reward. That means if you’re a short-term investor, or looking to stay mostly liquid, then this strategy probably isn’t right 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 the first year which is then multiplied year after year based on the interest rate received.

Reading: Compound interest portfolio

Let’s say you make a $100 investment and receive a 7% rate of return in your first year. the interest has not yet been capitalized as it is in the initial stage of investment.

but then during the second year you get another 7 percent return on the 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 compound interest earned for the first through second years, as it is interest earned on top of the initial $7 in interest earned after the first year. the $7 earned in the first year is simple interest. after this initial simple interest is earned, that’s when interest begins to earn interest, which is what is defined as “compound interest.”

This may not sound like much, but compounding really takes 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 roughly the historical average return of the s&p 500 since its inception, and the 7 percent can be considered relatively conservative).

year 1: $20,000 x 1.07 = $21,400

year 2: $21,400 x 1.07 = $22,898

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In two years, you’ll have earned nearly $3,000 at $98 compound interest, just by keeping it invested.

use the rule of 72 to estimate when your money will double

Over your lifetime, you can double, triple, or “go to the moon” on 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 for your money to double at a specific 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 work out that 72/7 = 10.28, so it will take about 10 years for your investment to double.

To maximize this strategy, it’s important to keep in mind that consistency (and courage) is key. the rate of return is an assumed average over decades, meaning that a winning strategy will experience various economic troughs and peaks that investors will need to overcome.

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 compounding right away with as little risk as possible, savings vehicles like 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 CD’s term reaches maturity, unless you pay an early withdrawal penalty, but you’ll 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 between three months and 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 earn a little more interest than if it were just in a checking account.

high yield savings accounts

High-yield savings accounts typically require no (or very low) minimum 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 wasted money. One of the main advantages of high-yield savings accounts is that you earn interest while still having the security and fdic insurance (up to $250,000 per account) of a traditional savings account. however, unlike most traditional savings accounts, you may be required to maintain certain minimum balances to receive the advertised interest rate. so you’ll want to make sure you select an account within the limitations you’re comfortable with.

While both CDs and high-yield savings accounts will generally pay more than having 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 may need to consider more aggressive options.

bonds and bond funds

Bonds are often considered a good compound investment. they are essentially loans that one gives to a creditor, be it a company or a government entity. that entity or company then agrees to give a specific return in exchange for the investor buying the debt.

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Note that you will need to reinvest the interest paid into a bond to compound the interest. bond funds can also achieve compound interest, but should be set to automatically reinvest the interest.

bonds will have different levels of risk. Long-term corporate bonds are riskier but offer higher yields, while US Treasuries are considered one of the safest investments you can make as they are backed by the full faith and credit of the US. uu. government.

Bonds can be beneficial to 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 over their life. As prevailing interest rates rise, existing fixed-rate bonds may decline in price. on the other hand, if rates go down, the price of the bond will go up. Regardless of what happens in the meantime, 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 interest rates than a traditional savings account, money market accounts often allow check writing and debit card privileges. These allow easy access to your assets while earning slightly higher interest than a regular savings account.

investments that can compound your money a little faster

With today’s low interest rates, it’s often difficult to compound with interest-only investments, but investors can also take advantage of compounding by investing in high-yield investments and reinvesting earnings.

dividend shares

While long-term stocks on their own are also a good investment for increasing growth, dividend stocks are even better. Dividend stocks are a one-two punch, as the underlying asset can continue to rise in value while paying dividends, and this investment can deliver compound growth if the payments are reinvested.

If you’re looking for dividend income, you may want to check out the group of stocks known as the “dividend aristocrats.” this group of s&p 500 index companies has increased dividends per share for at least 25 consecutive years. Some companies on this list include Coca-Cola, Walmart, and IBM. therefore, for a first-time investor looking to potentially beat inflation while increasing long-term income, dividend stocks and dividend aristocrats are a good way to go.

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 higher-growth stocks would.

real estate investment funds (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 in the form of dividends each year. As with other dividend stocks, investors must reinvest their payments to enjoy the benefits of compounding over time.

Reit investors should be aware that these investments are quite different from a savings account or CD. Reits are sensitive to fluctuations in interest rates, which affect the real estate market disproportionately compared to other assets. And unlike very safe banking products, the price of Reits can go up and down a lot over time.

end result

Less risky compound interest investments like CDs and savings accounts will be safer options, but are more likely to give you a lower return. Options like REITs and dividend stocks can earn you a higher return with dividends reinvested, 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 on investment strategies before making an investment decision. furthermore, investors are cautioned that past performance of the investment product is not a guarantee of future price appreciation.

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