Overlooking the benefit of compound interest is like throwing money out the window. Even if you only invest money in a savings account for the compound interest, you’re letting your money earn money. It’s the smartest financial decision you can make.
If you aren’t taking advantage of compound interest, here’s everything you must know about it and the 11 best compound interest investments to consider.
What Is Compound Interest?
Compound interest is the interest you earn on top of your interest, which may sound confusing.
So any interest you earn on your initial contribution earns interest, and that interest earns interest, and the cycle continues as long as you leave the funds in the account.
As you can imagine, compound interest can drastically change your net worth, especially if you can leave the funds invested long-term. For example, if you invest for retirement and leave the funds untouched for 30+ years, that’s a lot of time for the interest to compound.
How Compound Interest Works
Let’s look at an example to see how compound interest works. Say you invest $1,000 and earn 7% interest.
- In the first year, you earn a 7% annual rate of interest. You’d earn $70, bringing your investment balance to $1,070.
- In year two, you earn 7% on the $1,000 and the additional $70. So instead of $70 in interest, you’d earn $74.90
It doesn’t seem like much of an increase, but if you leave the money long-term, the compounded interest adds up. Imagine the difference over 30 years – it dramatically affects your balances.
When considering compound interest, there are three key factors.
- Interest: This is the rate of return. Obviously, higher interest rates are better because you’ll earn more during each compounding period.
- Compound Frequency: The more frequently interest compounds, the more you’ll earn. For example, monthly compounding grows faster than annual compounding, and daily compounding grows faster than monthly.
- Duration: How long you keep the money in the investment determines how much your interest compounds. For example, if you keep it in an investment for six months that compounds monthly, you’ll earn less than if you left it for 36 months.
Simple Interest vs. Compound Interest
Many confuse simple and compound interest, but you should understand the difference. You only earn simple interest on the principal amount, not on any interest earned. In other words, the interest doesn’t compound.
Using my example from above, you’d earn $70 per year; the amount of interest won’t change. In a perfect world, your debts would have simple interest, and your investments would have compound interest.
Of course, that’s not always the case, so it’s best to understand what you’re receiving to ensure your investment will deliver what you hoped.
Which Types of Accounts Offer Compound Interest?
Many accounts offer compound interest but always read the fine print. If I told you savings accounts pay compound interest, for example, that doesn’t mean every bank offers a savings account that pays compound interest.
Many investments offer the opportunity to earn compound interest, but always look at what they offer and compare the interest rate (if it’s a bank account) and the compounding frequency. Do the math to determine which account makes the most sense. For example, sometimes, the accounts paying lower interest rates but with more frequent compounding will yield the best results.
11 Best Compound Interest Investments
Here are the best compound interest investments to grow your money faster:
- High-Yield Savings Accounts
- CDs
- Money Market Accounts
- Mutual Funds
- Peer-2-Peer Investing
- Real Estate
- Bonds
- Stocks
- Treasury Securities
- Alternative Investments
- ETFs
1. High-Yield Savings Account (HYSA)
High-yield savings accounts often pay much higher APYs than standard savings accounts, and you still have access to your funds as needed.
HYSAs are typically online and may have higher deposit requirements to earn the highest interest rates, but you’ll likely earn more.
One word of caution with HYSAs, though, is the interest rates are variable. They can increase or decrease at any time. Rates typically decrease during economic downtimes and increase when the economy does well.
Reading the fine print is the key to making the most out of your HYSA. Some offer tiered interest rates, paying higher rates for higher balances. Find out how much you must invest to reach the highest tier when choosing between accounts.
While HYSAs are liquid, they have the same rules as regular savings accounts. For example, you can’t make more than six withdrawals without paying the penalty and/or risk losing your account.
Like regular savings accounts, most HYSAs are FDIC insured, so even if you’re unsure about banking online, the FDIC insurance ensures you will receive your funds back if the bank fails, up to $250,000 per depositor.
HYSAs are great for short-term goals because you allow your money to grow but have access to it when needed.
2. Certificates of Deposit (CDs)
You can find certificates of deposits or CDs at almost any local and online bank. CDs are similar to savings accounts, but they have a timeline. You must keep your funds in the CD for the whole term. If you withdraw funds prematurely, you’ll pay a penalty, usually three months of interest.
You can invest in CDs from three months to five years, and like most investments, the longer the term, the higher APY you earn.
Unlike savings accounts, the rates on CDs don’t change. Instead, you lock in the rate for the specified term. If locking your funds up for the long term scares you, try the CD ladder method.
Instead of putting the entire principal in one CD, split it up among several CDs, each with different maturity dates. For example, you can have CDs maturing every six months, so you always have access to funds and leave some of the funds in a long-term CD to earn the highest rates.
If you don’t need the funds when the CD matures, you can reinvest them in another CD and continue the ladder.
CDs, like savings accounts, are FDIC-insured up to $250,000 per depositor, so your money is safe but should be kept in the CD until it matures if possible.
3. Money Market Accounts (MMAs)
Money market accounts are a cross between savings and checking accounts. They pay higher interest rates than both because they typically require much higher balances. Like HYSAs, they may pay tiered interest rates, paying you higher rates for more money deposited.
You can find Money Market Accounts online or at your local bank. Compare your options, including interest rates, deposit requirements, and fees, to help you choose the right account.
Unlike HYSAs, you get check-writing privileges with MMAs. You’re still restricted to the six withdrawal limit, but you can write checks from the account instead of withdrawing cash at the bank and dealing with cash.
Read the fine print before opening an MMA to determine the minimum account balance threshold. Not only do some banks require a minimum opening deposit, but many also require a minimum ongoing deposit, or you might pay a penalty.
MMAs are a good way to grow funds you need in the short-term, but when you have enough to meet the minimum balance requirements. So why not let your money grow while you don’t need it and then have access to it when you do?
4. Mutual Funds
Mutual funds are also baskets of securities; however, fund managers actively manage them. They decide which funds to include and when to buy and sell them.
Mutual funds may include an assortment of assets, including stocks, bonds, and other assets. As a result, the price of mutual funds fluctuates throughout the trading day. The value depends on the value of each asset within the fund. Its net asset value is determined when mutual funds trade at the end of each trading day.
As a mutual fund investor, you don’t own the securities in the fund but instead, own a share of the total fund. The goal of most mutual fund managers is to beat the index the mutual fund is tied to, such as the S&P 500.
Mutual funds are best for longer-term investments of at least three to five years, as that’s how long it takes for most funds to beat the market.
Investors can buy and sell mutual funds at the end of each trading day. They also can reinvest any dividends earned from securities within the fund.
While your investment as the mercy of the fund manager, if you do your due diligence and find a reputable fund manager with experience and investment ideas that align with yours, it can be a great way to have a hands-off investment that compounds its earnings.
5. Peer-To-Peer (P2P) Investing
Peer-to-peer investing allows investors to operate as a bank. Instead of borrowers going to a traditional bank to get a personal loan, they come to P2P lenders. Most borrowers using this option don’t qualify for traditional bank financing, so they might be at higher risk, but risk usually means higher rewards.
P2P platforms rate borrowers after doing their due diligence. They evaluate their income, assets, credit, and liabilities to determine their likelihood of repaying the loan.
Most P2P platforms allow investors to spread their investments over many loans. So, for example, if they have a $25 minimum, and you have $5,000 to invest, you can invest in as many as 200 loans or split the principal up how you see fit.
Like any investment, it’s a good idea to diversify your risk by investing some money in lower-grade loans and other money in higher-grade (less risky) loans.
Any investment in P2P lending is riskier than an HYSA or MMA, but you’ll typically receive higher interest rates, even on the ‘low risk’ loans.
As an investor, you’ll earn principal and interest payments based on the percentage of the loan you invested in. You will receive the full principal you invested back by maturity if the borrower makes the payments on time.
6. Real Estate
There are many ways to invest in real estate and earn compound interest. Whether you have the capital to invest directly in real estate or a lesser amount, there are options.
Physical Real Estate
Buying and holding physical real estate is a great way to compound your earnings. You earn monthly rent from the tenants and can also take advantage of the home’s physical appreciation, whether you upgrade it or the market naturally increases.
Owning physical real estate means you’re a landlord, so keep that in mind. It’s a full-time job that requires you to be available for maintenance, repairs, and tenant issues. You can run the property yourself or pay a property management company to handle it.
REITs
Real estate investment trusts (REITs) are pooled investments that allow individual investors to invest in commercial-grade real estate. Most commercial real estate is out of the realm of possibilities for individual investors, but REITs make it possible.
A REIT is a real estate company that buys, runs, and sells commercial properties. Investors can buy shares of the company and get a piece of the profits of the commercial properties. Like any real estate investment, there’s risk involved whether the companies renting the properties fold or the real estate company doesn’t run a proper investment.
As an investor, you don’t have control over which investments the REIT chooses, but you reap the earnings of any investment in the fund. REITs must return 90% or more of their profits to their shareholders, so it’s a good way to get involved in real estate investing.
Crowdfunded Real Estate
Crowdfunded real estate means you pool your funds with other real estate investors to buy and manage properties. Like REITs, you don’t have a say in which properties they purchase. Each fund invests in different properties, but you can read the fund descriptions to determine if they fit within your risk tolerance and goal timelines.
The nice thing about crowdfunded real estate is beginning investors can try it, as many platforms require an investment as low as $10 to start.
Like any real estate investment, there’s always a risk, so do your due diligence first.
7. Bonds
Bonds are a low-risk investment, especially if you invest in government bonds. They don’t earn much interest, but they can be a great way to diversify a risky portfolio.
Bonds are a loan to a government agency or company that pays you back principal and interest. The longer you hold the bonds, the more interest you earn, but the longer your funds remain tied up.
There are many bonds to choose from, including no-risk government bonds and corporate and municipal bonds.
The riskiest bonds that also pay the most interest are corporate bonds. This is because rather than loaning money to a reputable government agency, you loan money to corporations for specific projects or capital.
With government and municipal bonds, you loan money to government agencies, including federal, state, and local agencies. They promise to repay the loan, make periodic interest payments, and repay the full principal when the bond matures.
Some bonds have a penalty if you cash them in too early, so understand the bond’s terms to ensure it meets your timeline and won’t cost you any penalties.
8. Stocks
Stocks are investments in individual companies. The key is investing in companies with a growth mindset that will be worth more than you bought them.
Some stocks pay dividends, a portion of the company’s profits that they pay back to investors. If you reinvest the dividends, you compound your earnings even further, but you aren’t required to reinvest them.
Stocks are one of the riskiest investments on this list because there’s no guarantee they will increase. In addition, you can lose your entire investment if a company collapses, so it’s best to diversify your investments.
If you put a lot of money into stocks, consider investing in different industries and stock types, including preferred and common stocks. It’s also best to include non-risky investments in your portfolio, such as bonds or treasury securities, so you don’t risk your entire portfolio.
If you only have a little money to invest in stocks, consider using a broker that allows you to invest in fractional shares. This means you can buy less than one share based on the amount you have to invest. Robinhood is a good example of an app that allows fractional share purchases.
9. Treasury Securities
Treasury securities are among the safest investments, but they pay lower interest rates because of their low risk. In addition, they are similar to government bonds, meaning there’s little risk of loss.
Common treasury securities include T-Bills and T-Notes.
T-Bills
T-Bills are short-term investments with four options – 4, 8, 13, 26, or 52 weeks. You buy the bills at a discount and earn the principal plus interest back at maturity.
T-Notes
T-Notes are just as low risk as T-Bills but have longer maturities of 2, 3, 5, 7, or 10 years. All maturities except 10-year T-Bills are auctioned off monthly, and the 10-year T-Notes are available every February, May, August, and November.
10. Cryptocurrencies and Alternative Investments
There is also the option to invest in crypto and alternative investments. These investments are the riskiest on the list but have the greatest return when they perform well.
Cryptocurrency is an investment in virtual currency, such as bitcoin. The crypto industry is volatile but has grown quickly. It’s best to only invest a small portion of your portfolio in crypto since it’s still fairly new and volatile, but it can be a good long-term, buy-and-hold investment.
Another common alternative investment is an investment in the fine arts. You can buy valuable art, store them and sell them for a profit when you’re ready, or use an app like Masterworks where you can invest in fractional shares of valuable art. Depending on the investment, you must hold onto your shares for 3 to 10 years, but then you can sell your shares for a profit on the secondary market.
11. Exchanged-Traded Funds (ETFs)
ETFs or Exchange Traded Funds are baskets of securities that track a specific index. While they don’t earn compound interest, I have included ETFs as they do have the possibility for compounded growth. A compounded profit can be achieved by reinvesting dividends.
The most common ETF tracks the S&P 500, but there are other indexes they can track too. The value of ETFs increases and decreases with the index, but because it’s well diversified, you don’t have to do anything except hold onto the investment long-term.
You can buy (or sell) ETFs during the market’s operating hours, and many brokerages, like E*TRADE, don’t charge commissions to trade ETFs.
ETFs are passively managed, which is how brokerages can keep costs down. There isn’t a fund manager actively buying and selling funds. Instead, they invest in every security in the index and leave it for the long term.
Beginning investors like ETFs because they’re automatically diversified, and you can buy ETFs in specific industries or markets. For example, if you want to invest in technology stocks, you can invest in a technology-focused ETF. This automatically diversifies your investment in the technology industry, reducing your risk.
Most robo-advisors invest your money in ETFs rather than stocks because they are easier to manage and are lower cost.
But because you can buy or sell ETFs any time during regular trading days, it’s easier to manage your portfolio should your financial goals or risk tolerance change.
How to Calculate Compound Interest
It’s simple to calculate compound interest. You start with your principal amount on what you initially deposited. For example, $1,000 and your interest rate, which I’ll use 5% compounded annually.
- In the first year, you’d earn $50 or $1,000 x .05 = $50, for a total investment balance of $1,050.00
- In year two, you’d earn $52.50 or $1,050 x .05 = $52.50, for a total investment balance of $1,102.50
- In year three, you’d earn $55.13 or $1,102.50 x .05 = $55.13, for a total investment balance of $1,157.63
Obviously, if you have interest that compounds monthly or daily, you’d compound the interest more frequently. If your interest compounds in any duration except annually, it’s best to use an online calculator as it can get complicated.
Pros and Cons of Compound Interest
Pros
Compound interest has many benefits, as you can imagine, including the following:
- It allows you to build wealth much faster, even without contributing more principal
- Works great when the compounding frequency is often
- You can invest for the short or long term and see a decent return on your investment
Cons
- You must keep the money invested for the long term to see the best results
- Compound interest works against you in anything but investments, such as debts, because your interest debt accrues faster than with simple interest
Tips for Choosing the Best Compound Interest Investment
No investment is guaranteed to make you rich or even to compound its earnings. To choose the best compound interest investment, ask yourself the following questions.
What Are My Goals?
Think about your goals and prioritize them. Shorter-term goals do best with liquid investments, such as an HYSA or Money Market account. You can access the funds quickly but will earn interest when you can leave the funds untouched.
If you have longer-term goals, consider higher-risk investments, such as stocks, ETFs, or real estate investments. Just make sure the maturity date coincides with your goal’s timeline.
How Much Risk Can I Tolerate?
Your risk tolerance plays an important role in which investments you choose. For example, just because you want to make a lot of money doesn’t mean you should invest in stocks. Think about the risk you can handle and not lose sleep at night.
How Much Can I Invest?
Some investments have minimum investment requirements. Make sure you can reach the minimum requirements and leave your money for the required time. Choose the investment that allows the amount of capital you’re willing to invest and has the risk you can tolerate.
Frequently Asked Questions
What Stocks Should I Buy for Compound Interest?
No stock guarantees compound interest, but choosing companies with a strong financial background and positive history is best. Consider companies like Apple, Amazon, Disney, Microsoft, and Netflix when investing in stocks. Always diversify your stock investments and invest money across many industries and risk categories.
Can You Lose Money With a Compound Interest Account?
There’s always the risk that you can lose money when you invest it. Risk-free compound interest accounts include High Yield Savings Accounts or Money Market Accounts at an FDIC-insured bank.
What Banks Offer the Most Compound Interest?
Bank interest rates change daily, so always check the latest rates. You’ll get the highest rates from online banks versus brick-and-mortar banks in your area. This is because online banks have less overhead and can pass the savings to their customers through lower fees and higher rates.
How Often Do Bank Accounts Compound?
Each bank compounds interest at different intervals. Always ask if it’s daily, weekly, monthly, quarterly, or annual compounding. The more frequently the interest compounds, the faster you can grow your money.
Who Are Compound Interest Accounts Best For?
Everyone benefits from compound interest, from kids to adults. Compound interest grows your money faster, helping you reach your financial goals. The younger you are when you invest or deposit funds in an interest-bearing account, the more money you’ll earn.
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