Saving and investing are great ways to build wealth, and you can build it even faster by selecting saving and investment products that compound your returns. This strategy creates a snowball effect, so the more you have, the faster it grows.
How Does Compound Interest Work?
Compound interest is interest paid on a principal balance — your deposits or invested funds — plus any interest that the principal has earned. It grows your money much faster than simple interest, which is interest paid on the principal alone.
The following table shows how each kind of interest would impact the value of a $5,000 investment earning 5% interest, compounded monthly, after three years.
|Simple Interest||Compound Interest|
As you can see, simple interest adds up to $250 per year, no matter how much the balance grows. Compounding increases the amount of interest earned each year.
Best Compound Interest Investments
Compound interest investments run the gamut from interest-bearing bank accounts to real estate investment trusts. Each has unique features that make it a good choice for the right investor. Here are eight of the best compound interest investments:
- High-yield savings account
- Money market account
- Certificate of deposit
- Mutual funds
- Real estate investment trust
- Exchange-traded funds
1. High-Yield Savings Account
A high-yield savings account pays more than the average savings account rate. In some cases, especially with online banks, high-yield accounts pay many times more.
Even the highest-yielding savings account might pay lower rates than you might get from investing your money in stocks, but it has none of the risks. The only way your balance can decline is if you withdraw money or the bank collects fees from the account. What’s more, savings accounts are FDIC insured, so your money is safe (up to $250,000) even if the bank goes under.
2. Money Market Account
A money market account is another type of savings account that typically pays higher interest than a standard savings account. In some cases, the rates are higher than high-yield accounts at online banks as well. MMAs have the additional benefit of providing a debit card and check-writing privileges.
An MMA is meant for longer-term savings, so federal law limits the number of convenience withdrawals, such as debit and check payments to third parties, you can make in a given month. The law is currently suspended, but some banks still impose the limit. You’ll want to keep that in mind if you’re considering using an MMA to replace a checking account.
3. Certificate of Deposit
A certificate of deposit is a type of deposit account, so it’s risk-free and FDIC insured. But CDs are time deposits — you agree to keep your money in the account for a predetermined length of time, called a term. Terms vary by bank and can fall anywhere from one month to 10 years.
Twelve-month CDs typically offer the best rates. Because your money is locked in for the entire term, you’ll pay a penalty if you withdraw funds early.
Corporations and government entities issue bonds to raise money. When you buy a bond at face value, or par, you’re loaning money to the corporation or government entity. The bond earns a specific interest rate on the face value as it matures, and at maturity, you also get back the face value.
Bonds are investment products, not bank deposits, so they’re not FDIC insured. While they’re a conservative investment, they’re not 100% risk-free, although some of the following types come about as close as you can get:
- U.S. Treasurys: The U.S. government issues two types of bonds. They’re long-term investments with maturities of five to 30 years, depending on the type. They’re backed by the full faith and credit of the U.S. government, which makes them extraordinarily safe.
- Municipal bonds: Municipal bonds, or munis, are issued by state and local governments. They’re conservative investments but are risker than Treasurys.
- Corporate bonds: Corporate bonds are issued by corporations, as the name implies. Investment-grade corporate bonds have higher credit ratings, so they are less risky than high-yield corporate bonds, which can earn higher interest but also have more risk.
5. Mutual Funds
A mutual fund pools money from a group of investors to purchase securities such as stocks and/or bonds. The types of securities in any particular fund depend on the fund’s objectives.
Mutual funds earn dividends from stock holdings and/or interest on bond holdings, which can cause shares to appreciate in value over time. You can also receive capital gains distributions when the fund’s securities are sold at a profit. Reinvesting these payments into additional shares compounds your returns.
If your broker offers a dividend reinvestment plan, or DRIP, you can use that to reinvest your gains automatically. Some brokers, including TD Ameritrade, will invest it in fractional shares on the date distributions are made, which leads to higher returns.
Note that mutual funds have fees that reduce your net returns. Read the fund’s prospectus carefully before you invest.
6. Real Estate Investment Trust
A real estate investment trust, or REIT, is a company that invests in real estate. When you invest in a REIT, you buy a share of that investment, which offers the potential financial benefits of owning income-producing property without having to buy the property yourself. Real estate investing always comes with risks, and REITs are no different. A REIT investing in many properties may be less risky than a REIT that invests in just one.
At least 75% of a REIT’s income must be invested in real estate, and REITs must return 90% of their real estate investment income back to investors as dividends. Reinvesting those dividends back into the REIT compounds the returns on your investment.
You can buy REITs through an online brokerage like Charles Schwab or through a crowdfunding site like Fundrise or RealtyMogul.
Whereas a mutual fund share is a share of ownership in a fund, a stock is a share of ownership in a corporation. A broker can buy and sell shares on your behalf or build you a portfolio automatically through its robo-advisor — or you can do your own trades through a self-directed brokerage account.
Individual stocks are a risky investment, but they may provide significant returns over time. You can compound those returns by reinvesting your gains, creating that snowball effect demonstrated previously. An easy way to do that is through the DRIP offered by your broker.
8. Exchange-Traded Funds
An exchange-traded fund is similar to a mutual fund in that it invests in a basket of stocks, but the fees are usually lower. And because they contain many stocks, not just one, ETFs are safer than buying individual shares. However, they trade in the same way as individual stocks, so you can buy or sell whenever the markets are open.
Brokerage DRIPs also apply to ETFs, so you can reinvest your gains to enjoy compounded returns over time.
The Secret to Maximizing Compound Returns
Because compounding is a cumulative process — the more you have, the more interest or appreciation you earn — time is your best asset. Starting early and saving or investing small amounts regularly grows your money exponentially faster than starting later but contributing more. However, keep your investments consistent with your risk tolerance and your overall financial picture. Never invest more than you can afford to lose, and always consult with a financial advisor if you’re unsure about the best investing strategy for you.
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