As an investor, interest is a key source of gains for your portfolio. It produces regular, predictable payments that you can plan around. Even more importantly, if you can harness the power of compound interest, it can help your investment grow over time. Here’s what you need to know about investing in compound interest.
A financial advisor can help you create a financial plan for your investment needs and goals.
What Is Compound Interest?
Compound interest is the interest you make on interest. Interest payments are issued based on a percentage of the underlying debt. For example, say someone owes you $1,000. They also owe you a 10% annual interest rate on that debt. In this case, they would owe you $100 the first year. Then, in the next year, say they’ve paid their debt down to $500. They would owe you $50 that year. The interest payments would change as borrowers pay off their principal (how much of the debt they still owe), while the interest rate (the percentage itself) would remain unchanged.
As a debtor, ideally this works in your favor. The more debt you pay off, the more your interest payments decline.
This can also work in the opposite direction, however. If the borrower doesn’t pay their interest in full, or otherwise reduce their debt, it gets added to the underlying principal. This is called “compounding.” The next time interest is calculated, that interest payment goes up based on the new, higher principal.
Take our example above again. Say someone owes you $1,000 at a 10% annual interest rate. This means a $100 payment for the first year.
Now, say they pay you $50. The remaining portion of the unpaid interest would get added to the principal, or “compounded,” and the debt would be worth $1,050 the following year. At 10% interest, the next year’s payment comes to $105. Say they pay you $50 again. Once more, we compound the unpaid interest, and our underlying debt is now worth $1,105. The interest payment on that is $110.50.
The interest payments increase each year as the balance gets added to the underlying debt.
Compound Interest vs. Compound Returns
It is very common for articles on this subject to conflate the concepts of compound interest and compound returns. For example, you may see articles that use stock portfolios as an example of how compound interest works. Here, they would use an example similar to ours above:
You make an investment of $1,000 and receive a 10% dividend. This produces $100, which you reinvest leaving you with $1,100 worth of stock. The next year you collect another 10% worth of dividends. Since this is 10% of your new $1,100 portfolio, you receive $110. Your portfolio is now worth $1,210, setting you up for a return of $121 the following year and so on.
This is an example of compounding returns, which is the growth that you make based on growth. Compounding returns are similar to compound interest, and generally use the same math, which is why many financial sites confuse the two subjects. In particular it’s common for financial sites to confuse dividend payments with interest payments. They can lead to similar portfolio growth, but each concept applies to different underlying assets.
Compound interest applies to payments made on a debt-based product, because interest applies to payments made on a debt.
How to Invest in Compound Interest
Investing in compound interest means investing in debt-based products that allow you to grow the underlying principal. This has its advantages and disadvantages.
The key advantage to investing in compound interest is that, like most debt-based investments, you typically will get safe assets. Debt-based products are backed by the credit of the institution behind them. Investment-grade assets rarely default, so you’ll usually see your money back. What’s more, compounding means that the growth in your portfolio will fuel future growth, leading to ever-larger gains over time.
The disadvantage is that, since it is a relatively safe investment, debt tends to generate lower gains than other investments. Your portfolio will grow more slowly with interest payments than with stocks or other, higher-risk assets.
If you do want to invest in compound interest, some assets you should consider include:
High-Interest Depository Accounts
High-yield savings accounts and money market accounts are probably your most basic form of compound interest investment. These are depository accounts where you hold money. The bank pays you interest on this account because it uses the money you hold on deposit. That interest gets added to your account, which increases the value of your account which, in turn, increases the next month’s interest payment.
As depository accounts, both a high-yield savings account and a money market account will be FDIC insured. They tend to pay interest rates of between 2% and 4% depending on the specific account, which is significantly more than many comparable depository options. However, it’s worth noting that even during ordinary times, this is barely above the Federal Reserve’s target rate of inflation, so your gains may at best break even with the value of money.
Certificates of Deposit
Also a banking product, a certificate of deposit is sort of like a super-savings account.
When you buy a certificate of deposit, or “CD,” you’re putting that money on deposit with the bank. You can’t access or withdraw it until the CD matures without paying a penalty. In exchange, the bank pays you a higher interest rate for your money. In November 2022, most CDs paid between 3% and 4.5% interest, depending on the value of the CD and the maturity. The larger your deposit and the longer the maturity, the more interest the bank will pay.
Certificates of deposit pay compound interest. Typically this means they pay you the annual interest rate amortized on a monthly basis. For example, if the interest rate is 4%, the bank will pay an interest rate of 0.33% per month (4%/12). A certificate of deposit is FDIC insured.
Bonds are an investment in debt. When a company or government wants to borrow money, it issues what’s called a “bond.” These are financial assets that represent a portion of the institution’s debt. For example, if you own a $500 bond from the U.S. Treasury it means that the United States government literally owes you $500. Every bond has an interest rate that it pays on a regular basis, typically every three months. It also has a maturity, which is the date on which the institution repays the face value of the bond.
For example, say you own a $500 bond with a 5% quarterly interest rate and a 20-year maturity. This means that, as the owner of the bond, every three months the underlying institution will pay you $25. Then, 20 years after the bond was issued, it will repay the $500 to whoever owns the bond at that time.
You can invest individually, by purchasing individual bonds, or in bulk, by investing in bond-based ETFs and mutual funds.
Individually, bonds pay simple interest. This means that you receive a set interest rate based on a fixed underlying principal. However you can make this an effectively compound interest rate by reinvesting your gains on a regular basis. For example, say you collect $100 worth of interest over the course of a year. At the end of the year you can purchase another $100 worth of bonds, effectively expanding upon your underlying principal.
In a fund, you can do the same thing. Your fund may issue yield payments based on the interest that your holdings paid. You can use those payments to purchase new shares in either that fund or another bond-based product. This is generally the easiest way to generate compound interest with bonds, as ETF and mutual fund shares are typically more liquid than bonds. You can also invest in a fund that automatically uses your gains to purchase new debt. This would give you the same result, just through the fund’s administration.
For most individual investors, the best way to invest in real estate is through a REIT, or “Real Estate Investment Trust.” These are portfolio-based assets that hold different forms of real estate and generate yields and returns based on their underlying investments. While many of these are restricted to accredited investors, you can find many other funds that are available to the general public.
When it comes to compound interest investment, this is a partial opportunity.
Many REITs invest in different forms of real estate debt. For the funds that do this, part of the portfolio’s overall yields will be based on the interest payments generated by this debt. As you earn money from those yields you can in turn reinvest it in the fund, buying more shares to increase your overall share of the principal in this portfolio. This will compound your gains over time, in the same way that reinvesting in bonds would.
This is a diversified form of investment though. A real estate investment trust will typically generate money from several different sources, such as rent and profit from operating its properties or the returns it makes from selling land. Interest payments will be a portion of your gains, but not all of them.
When you invest in compound interest, you are buying a debt-based asset that uses its own growth to further grow over time. The best way to invest in compound interest is with banking products and bonds.
Tips for Investing
- A financial advisor can help you decide how to allocate assets in your portfolio for retirement. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Whatever your time horizon for an investment might be, it’s important to know where you stand. SmartAsset’s free investment calculator can help you estimate how much you will have in 10, 15 or 20 years.
Photo credit: ©iStock.com/Ridofranz, ©iStock.com/ljubaphoto, ©iStock.com/patpitchaya