Compound interest helps your money grow exponentially faster than it would if you were only earning interest on the amount of money you started with. Why? Because compound interest lets you earn interest on interest, so it gives your savings the chance to take on a life of its own.
If you want to take advantage of compound interest, it can help to know how it works and which types of accounts let you harness its power. Here are the details for the compound interest formula and the best compound interest accounts you can sign up for.
What is compound interest?
Compound interest is a phenomenon that lets you earn interest on interest you already earned, and it can be illustrated with some basic math.
Imagine you have $100 invested, and you show an 8% return after the first year, leaving you with $108. You maintain the $108 invested in the following year and earn an 8% return again. Because of compound interest, you would earn 8% on $108 and end the second year with $116.64 in your account — and so on.
After 30 years, you would have $1,006.27. That may not seem like a ton, but it means your initial investment would have grown 10 fold. If the interest didn’t compound, you’d only have $340 after 30 years.
“Compounding interest allows it to grow over time, and take on more significance, much like a snowball rolling downhill,” said Sameer Samana, a chartered financial analyst with the Wells Fargo Investment Institute.
“Compound interest is where you earn interest on interest,” he said. “Simple is where you earn interest on just the initial investment.”
How to earn compound interest
Compound interest is one of those situations where you need money to make money. By putting down some cash in one of the best compound interest investments, you can start earning interest that will one day earn interest on itself.
Another step to earning compound interest is investing your money and leaving it there. The power of compound interest diminishes if you’re taking withdrawals from your account or selling the underlying investments that earn interest in the first place.
“With compound interest, every dollar you save works harder and grows faster,” said financial advisor Jeff Rose of Good Financial Cents, adding that you need to leave the money to grow for the best results.
For example, saving $200 per month for 30 years in a compound interest account means you will have deposited $72,000 over that timeline. With a 10% return, however, that $72,000 investment turns into well over $394,000.
The rule of 72 for predicting compound interest
Compound interest may be the secret sauce that gets you to retirement on or ahead of schedule. But how can you forecast what your returns will look like years into the future? Many people use compound interest calculators, historical stock market returns or both to estimate what their investments might be worth decades from now, but even that’s just a guess since no one has a crystal ball — and since past returns never guarantee future results.
That’s where the “rule of 72” comes into play. This simple formula can help you predict how long it might take for your investment to double in value. While it too is just a general “back of the napkin” calculation, the rule of 72 is an easy way to quickly estimate the results of compound interest.
How does the rule of 72 work? All you have to do is take the number 72 and divide it by the rate of return you anticipate an investment to achieve. For example, if you are keeping money in a high-yield savings product and you believe you’ll earn 5.00% APY for the foreseeable future, you would divide 72 by 5 to get 14.4. This means your investment would take 14.4 years to double in value with this fixed return. If you started with $100,000, you would have $200,000 after 14.4 years.
If you believe you’ll earn a higher rate than that through stock market investments, you’ll ratchet up your estimated return. Let’s say you have an index fund that tracks the S&P 500 and you decide to use the historical return for this index for the last 20 years (approximately 9.693%). If you take the number 72 and divide it by 9.693, the rule of 72 says your investment will double in just over 7.42 years.
If you had $500,000 invested and used this metric to predict your returns, the rule of 72 says you’ll have approximately $1 million in just under 7.5 years (7.42 years).
Best compound interest investments
All kinds of compound interest accounts exist, but some may work better for you based on your goals. For example, you’ll want to know how soon you might need the money before you decide, and you’ll need to consider your complete investment strategy to find the right fit.
High-yield savings accounts
High-yield savings accounts are popular for compound interest when rates are attractive, and it’s easy to see why. These accounts often come with low minimum balance requirements and no monthly fees, and they earn interest on deposits until you take the money out.
Some of the best high-yield savings for compound interest come from this type of account, but you’ll want to make sure to compare all your options before you get started.
Also, remember that the best online banks usually offer high-yield savings accounts with the best rates and no hidden fees. These accounts also come with standard Federal Deposit Insurance Corp. (FDIC) insurance or National Credit Union Administration (NCUA) insurance as long as the institution is federally insured.
Money market accounts
A money market account is a type of bank account offered by traditional banks and credit unions. This type of account is similar to a savings account but tends to come with check-writing privileges and may also come with a debit card.
Money market accounts are also protected by FDIC insurance from traditional banks or NCUA insurance if you bank with a credit union. Money market rates can be competitive and make it that much easier to earn compound interest on your deposits.
Certificates of deposit (CDs)
CDs are a type of savings account that requires you to “lock up” a certain amount of money for a set period of time (usually 3 to 60 months, but potentially longer). You’ll also lock your interest rate in during that time, so you can count on earning a certain amount of interest during your CD’s term.
You can earn compound interest with CDs by letting them mature and using the proceeds to buy another CD with a higher amount. CDs also come with FDIC insurance.
However, you’ll typically have to pay a penalty if you need to access the funds in your CD early. An exception is when you shop around and find a type of CD called a no-penalty CD that doesn’t charge any fees for early access.
Mutual funds
A mutual fund is a type of investment that pools money from multiple investors to purchase securities like stocks and bonds. This means that investors in mutual funds can have a stake in multiple investments at once, which is good news when it comes to diversification.
Depending on the underlying investments, mutual fund shares don’t necessarily earn compound interest, but they do have compound growth. Also, remember that mutual funds can (and often do) lose money in the short term.
Bonds
Bonds are a type of debt you can purchase as an investment. Similar to an IOU, this type of investment earns a regular return that can be compounded the longer you hold on.
There are various types of bonds to consider for compound interest, including corporate bonds, municipal bonds and U.S. treasuries. Government bonds like municipal bonds and U.S. treasuries are typically considered the safest since state, local and the federal government are the least likely to default on their debts.
Real estate investment trusts (REITs)
A real estate investment trust (REIT) is a type of investment that lets individuals put their money into large-scale real estate projects without having to deal with physical property. Similar to a mutual fund, this type of investment lets you buy shares and own a piece of the action and profits. And when the value of a REIT goes up over time, this type of investment earns compound interest that has the potential to snowball.
REITs typically purchase real estate to produce income, and they oversee these projects and manage them or hire third parties to help manage them. Properties held in REITs can include apartment buildings, commercial real estate holdings, hotels, self-storage facilities and more.
| Best for | Type of returns | FDIC or NCUA insurance | Minimum investment amounts | |
|---|---|---|---|---|
High-yield savings accounts | Short-term savings; easy account access | Variable rates that fluctuate based on market conditions | Yes | Varies (can be as low as $0) |
Money market accounts | Short-term savings; easy account access | Variable rates that fluctuate based on market conditions | Yes | Varies (can be as low as $0) |
Certificates of deposit (CDs) | Short-term to mid-term savings; guaranteed rate | Fixed rates that last for the duration of the CD term | Yes | Varies (often $500 or more) |
Mutual funds | Long-term investing | Returns based on market conditions | No | Varies (often $500 to $3,000) |
Bonds | Long-term investing | Can be fixed or variable returns based on market conditions | No | Varies (may be as low as $25) |
Real estate investment trusts (REITs) | Long-term investing | Returns based on market conditions | No | Varies (often $1,000 to $2,500) |
How to earn compound interest
While the list above includes some of the best compound interest accounts, keep in mind that you can earn interest that compounds on many other types of investments.
Here’s what you need to do to start earning compound interest today.
Step 1: Pick an account. Compare the best compound interest accounts available to find the right fit for your investing goals and tolerance for risk. For example, you’re guaranteed to earn interest that compounds in a high-yield savings account, whereas investing in mutual funds, bonds or other types of accounts that have the potential to grow can also result in losing money.
Step 2: Open an account. Take steps to open an account that earns compound interest next, but be aware that the steps required to open an account vary. For example, you can easily open a high-yield savings account or a CD online by providing some basic personal information and your Social Security number (SSN).
Step 3: Invest some money. You need to invest some money if you want to earn compound interest, and the minimum amount required to invest varies by account. For example, some CDs require a starting deposit up to $1,000 or more. You may also need a minimum amount to invest in mutual funds or individual stocks with certain investing platforms.
Step 4: Continue investing. You have the potential to earn compound interest by investing an initial sum of money. However, your potential for growth compounds even more if you keep investing money all along.
Step 5: Leave your money to grow. Most importantly, leave your money to grow and compound and resist the urge to sell your investments or cash your account out. Compound interest becomes more powerful over time due to the nature of how it works.
Frequently asked questions (FAQs)
Compound interest can be helpful for early retirement when someone has the foresight to begin investing for the long haul early in adulthood. After all, investing early gives compound interest more time to work.
How compound interest is taxed depends on the type of investing that has taken place. For example, compound interest earned on individual stocks, mutual funds and bonds isn’t taxed until the investment is sold and a gain is realized. With a high-yield savings account or CD, however, investors have to pay taxes on interest for the year it was earned.
Some compound interest accounts have the potential for losses, whereas others do not. For example, you cannot lose money with a high-yield savings account or CD, but you can lose money with investments such as individual stocks, mutual funds, bonds and other more volatile investments.
Compound interest is typically used for retirement savings. That’s because money kept in retirement accounts like 401(k)s and IRAs has a lengthy timeline for compounding that helps it grow.
Ultimately, retiring becomes easier when you start saving for it as early in your career as possible. For compound interest to do its job, it needs time more than anything else.
