Albert Einstein once called compound interest man’s greatest invention, remarking that “Compound interest is the 8th wonder of the world. He who understands it earns it; he who doesn’t pays it.”
Investors are very aware of the power of compound interest and are always on the lookout for the various types of investments with compound interest.
What Is Compound Interest?
Benjamin Franklin explained compound interest best, saying, “Money makes money. And the money that money makes money”.
The U.S. Securities and Exchange Commission defines it as the interest earned on interest.
Instead of paying it out, reinvesting interest means that interest in the next period is earned on the principal plus the previously accumulated interest.
When you are paying it out on credit card debt, it is a powerful thing indeed, but if you are earning it, it’s easy to see the magic of it.
What Are Compound Interest Investments?
Compound interest investments are any investments that not only earn interest but allow you to reinvest that interest.
Interest is a concept that should be used loosely. It refers not only to fixed interest from owning bonds or other fixed-income instruments but dividends as well.
The potential of compound interest comes alive when you have a long-term horizon and a snowball effect on your investment.
Can Compound Interest Make You Rich?
Warren Buffett is the most famous exponent of the virtues of compound interest. In 2018, he had grown his fortune by 7,268%, earned a 2 million percent return for investors, and was worth $72 billion, thanks to compound interest. In 2022, his fortune has swelled to over $140 billion.
We all can’t be Buffett, but we can use the same principles to get rich within our lifetimes. The key is to stay invested in asset markets and invest with a long-term horizon.
7 Types Of Investments With Compound Interest
There are several conservative investment bets that you can make which, if held across your life, can make you rich. They range from investing in retirement accounts to holding securities and are all united by the use of interest to explode your net worth.
- Roth IRA
As soon as a person starts to earn taxable income, they should invest in a Roth IRA. Under current tax law, money in a Roth IRA will not be taxed if you wait until retirement to withdraw your earnings.
If, for instance, a 25-year old invests $5,000 a year into a Roth IRA with an average annual return of 8%, they will have $1.6 million in savings by the time they retire at 67.
- Certificates of Deposit
Certificates of deposit(CD) offer high-interest rates and lock up your investment for a fixed term. Terms typically range from six months to five years. When the period has ended, you can renew your investment in the CD.
There are penalties for early withdrawals, and you cannot put fresh capital into a CD during the term.
- High Yield Savings Account
You will be able to withdraw and deposit funds as you wish and will get solid returns, though at a lower rate than CDs.
The fact that you can put more money into a savings account anytime you wish makes them more powerful than CDs and allows you to juice up compound interest.
- Invest in Dividend Paying Stocks
Earnings from dividends are less secure than the yield from bonds and savings accounts, but investing in dividend-paying stocks offers the potential to benefit from a higher overall return, or what is known as total shareholder return (TSR).
Instead of withdrawing your dividends, reinvest them in the stock, which means you will not have to pay any taxes, and you can maximize your TSR.
- Invest in Dividend-Paying ETFs
ETFs, take away the pressure and responsibility of finding individual stocks. Reinvesting these dividends into the ETFs will earn even more dividends and snowball your investment returns.
Paul A. Merriman offers a valuable example of using compound interest to build wealth for a newborn.
- Invest in REITS
Real estate investment trusts (REITs) expose the real estate market. They own properties and earn rentals or realize capital gains from those properties. Rentals and realized capital gains are distributed to investors in dividends. You can and should choose to reinvest those dividends to keep the compound investing cycle going.
- Invest in High-Yield Corporate Bond Funds
High-yield corporate bond funds invest in the investment-grade bonds issued in the United States. They are riskier than U.S. government or agency bonds, which is why they offer a higher return.
Summary
Compound interest is a magical and powerful force that can turn a modest sum of money into a fortune, given a long-term investing horizon.
Investors should invest with the idea that they will not make any withdrawals for a very long time. That is the only way to gain from compound interest. There is a snowball effect as time goes on, and your wealth starts to grow at exponential rates.