Have you ever played a game of cards where your victory depended on how wisely you played the cards in your hand? It’s a similar concept when it comes to your financial life. There are various strategies like saving and investing that you can use to achieve success, but just like having an ace up your sleeve that can help you come out on top, there’s one wild card that could give you a significant advantage – compound interest investments.
Albert Einstein once called compound interest the eighth wonder of the world. After you understand how it works and the powerful effects it can have on your financial life, you’ll see he was not wrong. Keep reading to learn about a couple of investments that will let you leverage the power of compound interest.
What is compound interest?
You can find a simple concept of interest within your own savings account. Generally speaking, when you keep your money in a savings account, the bank uses it to make loans to others. In return, the bank gives you a portion of the resulting revenue as interest.
Likewise, in the world of investing, interest is referred to as the amount of money you earn for trusting your money to a specific investment.
Now, whether it is in your investments or in your savings account, interest doesn’t normally get compounded. Compound interest is the effect of adding your interest to your capital to generate greater interest, which is added to the capital itself and generates even greater interest, and so on.
Let’s make it easier to understand with an example.
Imagine the capital in your savings account is $100. After one year without spending that money, the bank pays you an interest of 5%; which in this case, it’s worth $5. Once you earn it, you have two options: you can decide whether to use that extra $5 you’ve got as a result of the interest rate to buy a delicious cup of latte coffee, or you can turn them into a part of the capital in your account.
Let’s say you decide to keep them in your account so now your capital is $105. Another year passes by, and now the 5% interest rate the bank will pay you, applies to your $105 instead of only $100. Now, instead of only $5, they’ll pay you $5.25, meaning you’ll have $110.25.
If you repeat the process, the year after that, the 5% applies to $110.25 meaning you’ll have $115.76. If you keep adding the interest to your capital, instead of spending it, it will keep compounding the money in your capital and periodically increasing your interest payments.
What are the best compound interest investments?
Believe it or not, your money can generate greater returns from several compound interest investments than just sitting in your savings account. Here are three options that can help you to make the most out of your hard-earned cash.
Dividend stocks
Dividend stocks are stocks from companies that pay dividends to their shareholders on a regular basis. Dividends are one of the benefits a company gives to investors as annual, semi-annual, or quarterly in form of cash payments in exchange for their investments.
Companies are not forced to pay dividends; that’s why many of them don’t. In each case, the board of the company analyzes its current economic situation and its plans for the future; in case of having available funds, shareholders receive dividend payments.
To turn your stocks into compound interest investments, all you have to do is to reinvest the dividends you earn on each period. For instance, let’s say you buy a stock from Company A, and at the end of the year, you receive a dividend of $2. You will want to use that money to buy fractional shares from the company instead of cashing it out and buying your beloved candy bar. In this way, the dividends you will earn next year will be calculated on greater initial investment capital.
High-Interest Savings Account
Dividend stocks are one of the best options if you’re planning to invest for the long term. However, in case of needing quick cash, a high-interest savings account may be a good compound-interest investment for you.
With this compound interest investment, the interest you earn depends on your initial deposit. Of course, the more money you start with, the higher the interest it will gain.
Again, let’s look at an example to make it clearer. Let’s imagine you set $10,000 in a high-interest savings account that offers 10% of annual interest.
| Simple interest | Compound interest | |
| Year 1 | $1,000 | $1,000 |
| Year 2 | $1,000 | $1,100 |
| Year 3 | $1,000 | $1,210 |
| Year 4 | $1,000 | $1,331 |
| Year 5 | $1,000 | $1,464 |
| Year 6 | $1,000 | $1,610 |
| Year 7 | $1,000 | $1,771 |
| Year 8 | $1,000 | $1,984 |
| Year 9 | $1,000 | $2,143 |
| Year 10 | $1,000 | $2,357 |
| Total interest earned | $10,000 | $15,937 |
As you can see, if you keep on adding your interest to your initial capital, you’ll always end up earning way more money (taking also into account that in this example we didn’t have any recurring deposits).
Just like in the previous example, the higher your investment is, and the more time you let your interest compound, the more money you will earn in the long run. Nevertheless, as we mentioned before, high-interest savings accounts have the advantage of letting you make use of your money if you ever run up into an emergency.
Certificates of Deposit
It might be considered the safest investment. Most banks offer certificates of deposit to provide a higher interest rate in exchange for leaving a big deposit without touching it for a predetermined period of time. Each bank decides what terms will be negotiated in the CD.
Despite being one of the safest investments, CDs offer a lower opportunity for growth. However, if you research well enough, you’ll find top-paying certificates of deposit that pay higher interest rates. When the certificates of deposit mature, you get both amounts of money, the principal and the interest.
The bottom line
Compound interest is one of the best tools you can use to maximize the potential of your investments. To determine which compound interest investment fits you best, make sure to take into account your financial situation and long-term goals.
Also, checking with a financial advisor is always an option too.
Another thing you can do to learn more useful strategies to improve your financial fitness is to keep on exploring the library of our articles. You will surely find some practical tips to save money as well as simple strategies to invest.
