Best compound interest investments
One of the most basic components for building wealth is the concept of compound interest, which the US Securities and Exchange Commission (SEC) defines simply as, “Interest paid on principal and on accumulated interest.”
In other words, as you accumulate interest in deposit accounts — or earnings in investment accounts — each successive interest payment is made based on that increasing amount. Therefore, compound interest investments can help you grow your money at an exponential rate.
Understanding compound interest investments
Compound interest is so robust over time that the Federal Reserve Bank of St. Louis called it “the single most powerful action that an individual investor can leverage to build wealth.”
Here’s a simplified example to explain how compound interest works: If you deposit $5,000 in an account earning 4% per year, you’ll have $5,200 one year later. That’s total interest of $200 in the first year. In the second year, you’ll earn 4% on $5,200, which comes to $208 in interest. After year five, you’ll be up to a total of $6,083.
There’s a popular calculation method that illustrates this power called the “rule of 72.” As the St. Louis Fed explains, this rule allows you to determine approximately how long it will take to double your money at a given interest rate.
The formula can be written as follows:
72 ÷ interest rate = years to double your money
Returning to our example above of $5,000 at 4% interest, if you divide 72 by four, your quotient is 18 — the number of years it will take to double your original deposit amount (without additional deposits). Check out this compound interest calculator provided by the SEC to see the formula in action.
The power of compound earnings also applies to dividend-paying stocks and other types of income-generating investments.
Best compound interest investments
These categories can provide some of the best opportunities for earning compound interest.
Deposit accounts
While every savings or investment account begins with a deposit, certain financial vehicles — generally opened at a bank or credit union — are known as “deposit accounts,” as follows.
- Checking accounts: Checking accounts are designed for frequent transactions, such as deposits and bill-paying, and may earn interest.
- Savings accounts: Traditional and high-yield savings accounts are meant for accumulating funds without many withdrawals, but transactions are generally allowed at will.
- Certificates of deposit (CDs): CDs typically offer higher rates than traditional savings accounts but come with additional requirements, including a required minimum deposit. You generally must also maintain your money in the CD — untouched — for a certain period of time (from three months to many years).
- Money market accounts: Money market accounts are another alternative to traditional saving accounts, which pay a higher rate of interest because they require a higher minimum balance, and are less restrictive than CDs.
Risks: The main risk of deposit accounts is if your account balance exceeds the limits offered by the Federal Deposit Insurance Corp. (FDIC)i or the National Credit Union Administration (NCUA). Accounts at federally insured banks and credit unions are insured up to $250,000 per depositor, per insured bank or credit union, per ownership category.
There is also opportunity risk — a better earnings opportunity could arise, but you’ve committed to something else — if you are choosing safety over the potential yield of, say, stocks.
Fixed-income investments
Fixed-income investments, such as bonds, CDs and preferred stock, are those that pay a fixed rate of return. However, the term “fixed income” is generally associated with bonds.
According to the SEC, “A bond is a debt security, like an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time” The issuer may be a government, municipality or corporation, which agrees to pay “a specified rate of interest.” Main categories include the following.
- Treasuries: Treasury bonds, issued by the US Department of the Treasury, include Treasury bills, which mature in four weeks to a year; notes, which mature within two and 10 years; bonds, which typically mature in 20 or 30 years; and Treasury Inflation-Protected Securities (TIPS), which are notes and bonds whose principal is adjusted based on changes in the Consumer Price Index (CPI). You can also buy savings bonds, which earn either fixed or variable interest.
- Municipals: Called “munis,” these are debt securities issued by states, cities, counties and other government entities.
- Corporates: Corporate bonds are issued by private and public corporations. They include investment-grade bonds, which have higher credit ratings and are relatively low risk, and speculative-grade bonds, which have lower credit ratings and relatively high risk. In exchange for the extra risk investors take with speculative-grade bonds, they offer higher interest rates. Thus, they’re often referred to as high-yield bonds.
Risks: The risks associated with bonds include the issuers’ reliability (credit risk), the impact of interest rates on bond prices (interest-rate risk), the rate of inflation (inflation risk) and potentially limited liquidity (liquidity risk).
Equity investments
In contrast to deposit accounts, where you own the account, and fixed-income investments, where you are lending money to an entity, equity investments typically involve your ownership stake in a company. Following are some main types.
- Dividend stocks: Owning stocks that pay dividends, and automatically reinvesting those dividends back into the company instead of withdrawing them, can be a powerful way to deploy compound interest.
- Real estate investment trusts (REITs): According to the SEC, “A REIT is a company that owns and typically operates income-producing real estate or related assets.” The trust may be publicly traded, nontraded or private. REITs are attractive to investors because they provide regular distributions of profits to shareholders, often based on rental income, that can compound over time if reinvested.
- Mutual funds and exchange-traded funds (ETFs): Mutual funds and ETFs “offer investors a way to pool their money in a fund that makes investments in stocks, bonds, or other assets and, in return, to receive an interest in that investment pool,” according to the SEC. If you leave the fund earnings, dividends and capital gains distributions untouched, their growth will compound exponentially.
Risks: Market volatility is a constant risk for equity investments, especially in the short term.
To sum up, “Where you decide to invest depends on your liquidity needs and your time horizon. Time horizon trumps everything else,” said Richard Colarossi, a certified financial planner (CFP) with financial services firm Colarossi & Williams. “Also, it depends on your goals — where you want to position your money and for how long.”
“With compound interest, CDs, high-yield savings accounts and Treasuries are short-term strategies,” he continued. “They will compound, but because they are offering liquidity and safety, they generally produce lower returns than a long-term equity or bond strategy. Equity-based growth, through reinvesting dividends, is a long-term strategy.”
Frequently asked questions (FAQs)
One tool to use is the rule of 72, which enables you to determine approximately how long it will take to double your money at a given interest rate. To do so, divide 72 by the interest rate. For example, if you deposit any amount at a 4% interest rate, you would divide 72 by four and see that it will take 18 years to double your original deposit amount (without additional deposits).
“Whenever you can combine compound interest with a tax-saving strategy, then you can maximize your gains,” said Luis Rosa, a CFP and the founder of Build a Better Financial Future, an investment adviser firm. For example, he said, “If you invest inside your workplace 401(k) plan, your funds will grow tax-deferred and will earn interest on your employer contribution as well. Also, if you qualify for a Roth IRA, and follow the rules, you will get compound interest that’s tax-free.”
“If you qualify for a health savings account, you have a great opportunity to use a pre-tax strategy similar to a 401(k),” said Rosa. “A lot of people don’t realize they can invest their unused HSA funds in compound investment vehicles. They can max out their contributions because they can carry them over to the next year.”
Yes, there are risks with compound interest investments, whether they are made in deposit accounts, fixed-income investments or equity investments. In a deposit account, balances above FDIC and NCUA limits may be at risk if the financial institution fails. Fixed-income investments also have risks, including interest-rate and inflation risk. And equity investments are always at risk of market volatility, meaning they can lose value. Always consult with a fiduciary financial advisor before making investments.