Compound interest is one of the most fascinating and exciting effects of math on your money. Basically, by making more money, you’re able to make even more money. As you plan out your long-term finances, you might aim to use compound interest to your advantage wherever possible.
You may already have a savings account that makes use of compound interest. When you see your bank statement, have you ever noticed that a small amount of money is added each month? That’s interest. We’ll cover how that works and how it compares with compound interest in this post.
Some people tend to be risk-averse; they’d rather know their money is safe in savings than risk putting it an investment account. The problem is, putting all your money in an ordinary savings account may keep it safe, but the returns might not even keep up with inflation — the amount that prices increase year-to-year, and so the relative value of the dollar decreases.
While you should have a savings account for emergencies, putting some of your money in even a moderately risky compound interest investment account has the potential for helping your long term financial prospects much more than letting it sit in savings. We’ll cover what kinds of compound interest accounts exist and how they work in this post. Read through for a quick guide to compound interest savings accounts, compound interest investments, and more. Or, simply click on a link below to jump straight to the section you need to see.
Compound Interest Explainer
First, let’s start with an explanation of interest and compound interest. What is interest? Simply put, interest is an amount that you are paid for, allowing the bank or investment company you work with to use your money. Part of how banks make money is by investing some of the money stored with them. They then can repay you a portion of those profits as interest. Investment accounts essentially do the same but more aggressively.
Compound interest is a type of interest. Unlike simple interest, which is calculated by multiplying your principal amount by the interest rate, compounding is a bit more complicated. Basically, each payment of interest is calculated based on the new amount of money in your total after the previous interest payment is added.
It’s easier to explain with an example. Suppose you put $1000 in an account that has a 3% rate of return. At the end of the year, you have $103. Now, in the following year, the 3% interest you expect to earn will be 3% of $103, not your original $100. As you might guess, that effect can snowball over time. Here’s a real-life example.
The graph above shows that regularly depositing money in an investment account with a reasonable rate of return can seriously boost your earning potential — much more so than simply depositing money into your savings. This is one of the reasons it’s recommended that you start saving for retirement early on. With just a consistent 3% compounding interest rate, in just 40 years your initial $1000 dollars, plus just $120 per month in investments, can result in over $110,000. Try out a calculator like the one on Investor.gov to see how much your current rate of savings could add up to with a compound interest account.
Now that you have a good idea of how compound interest works, you’ll probably want to know how to harness that to better grow your savings by using a compound interest account.
Compound Interest Account Options
When it comes to finding the ideal account for your funds — and taking advantage of compound interest — you have a number of options. We’ll cover them in order from those that tend to be less risky to those that are higher yield but carry more risk.
High Yield Savings & Money Markets
An average traditional savings account generally offers an interest rate hovering around 1% or lower. Given that the US inflation rate is around 2%, that means you actually lose money year-to-year by leaving your cash in a traditional savings account. That’s where high yield savings and money market accounts come in. There are a couple of distinctions to know between the two — high yield savings may put some of your money in a low-risk investment portfolio, while money markets invest in debt products like treasure bonds and certificates of deposit (CDs). However, they often yield the same result: a higher interest rate on the money you deposit.
Usually, you can expect anywhere between 1.5% to 2% APY (annual percentage yield) in interest on a money market account. The interest on these accounts is usually compounded daily and then paid out monthly, so the amount of money you’re earning is always building on the new amount.
Retirement funds usually come in two forms: 401ks and IRAs. Both are essentially just moderate-to-low-risk investment accounts that are intended to grow over time and help you build substantial savings before you leave your career in retirement.
- 401ks are issued through your employer. If you’re signed up for your employer-provided 401k, you’ll probably see a portion of each paycheck that’s taken out and put in your account. Some employers offer a matched contribution too — that means they will put the same amount of money in your 401k that you put in it (up to a point). If your employer offers this, be sure to take advantage to get the most out of your 401k.
- IRAs are personally managed. You can open an IRA with most banks and investment brokers. There are two main types: traditional IRAs and Roth IRAs. Traditional IRAs are not taxed until you withdraw from it after you retire (or, if you withdraw before retirement, you may face steep tax penalties). Roth IRAs are funded by your post-tax income, so you won’t have to worry about taxes when you withdraw during retirement. Just be sure not to withdraw before then, as you will face tax penalties in that case.
Both retirement account types employ the power of compound interest to grow your money. This is important, because, as you saw in the example above, having 40 years to take advantage of compound interest can mean you take full advantage of its effects.
Another way that you can take advantage of the compounding effects of investing is through dividends. Now, a quick disclaimer: technically, dividends don’t work by providing compounding interest, but you can basically create the same effect with clever investing. Here’s how it works.
As opposed to a regular investment, where you buy stock and hope that it grows in value before you sell it, dividend stocks pay a portion of revenue to investors on a quarterly, semi-annual, or annual basis. How can you use this to take advantage of compound interest? By reinvesting your dividend payouts. Say you own $100 in $50 shares (so two shares) at 5% payout. After ten payouts, you’ll have the chance to buy another share — which will increase the dollar value of your payout in each one that follows. Compounding investments yourself may not be as immediate as with other accounts, but because dividend investing can have higher rates of returns than money markets or some retirement accounts, you might see your funds start to add up quickly.
Investment accounts are a simple and effective way to see your funds grow quickly through the power of compound interest. When you open an investment account through a traditional investor, like TD Ameritrade or Merrill Lynch — or new web-savvy robo-investors like Wealthfront and Betterment — your money is invested in a diverse allocation of stocks and bonds.
Companies like those mentioned allow you to choose your risk tolerance, what sorts of companies you’d prefer or prefer not to be invested in, and your purpose and time horizon. Your investments are then professionally managed by an advisor or algorithmic advisor (or a combination) to keep up returns. Many companies have the option to open investment accounts, IRAs, and bank accounts with them, too, so you can conveniently manage all your money in one place while still enjoying the benefits of compound interest.
You could also directly invest in companies on the stock market. This is riskier, but the returns can be much more immediate and substantial if you make a lucky and well-advised bet.
Get Sound Financial Advice and Diversify
Of course, it’s not a good idea to put every spare dime into stocks, or just throw extra money at the stock market without doing your homework first. People have lost fortunes in the stock market, sometimes due to short-sighted investing, and sometimes due to factors beyond their control.
If you want to start investing, get your day-to-day finances in order first. Create a budget using great online tools like Mint, get three to six months’ worth of living expenses in a compound interest savings account for emergencies, max out your IRA or 401K contributions, and generally make sure you and your family are on sound financial footing.
Don’t start compound interest investments without learning about your choices beforehand. Many community colleges offer basic courses in investing that can be well worth your time. Working with a certified financial planner is not just for the wealthy but can be a very smart move for the middle class investor too. Just make sure to do your research first and choose carefully.
Once you start investing, you can use tools like Mint to help you track your investments. You can also learn more about your personal investment style, and use Mint to expose fees hidden on financial statements and in the fine print that reduce the long-term growth of your investments. Educate yourself, enlist in the advice of investing experts, and use Mint to track your budget and investments — you can set yourself up for the brightest financial future.
Sources: Investor.gov, Compound Interest Calculator | IMF, United States and the IMF