4 ways to invest in compound interest

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SmartAsset: how to invest in compound interest?

SmartAsset: how to invest in compound interest?

As an investor, interest is an important source of profit for your portfolio. It delivers regular, predictable payments that you can plan around. 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. Say someone owes you $1,000. They also owe you 10% annual interest on that debt. In this case, they would owe you $100 for the first year. Then, in the following year, suppose they repaid their debt up 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, this ideally works to your advantage. The more debt you pay off, the more your interest payments decrease.

However, this can also backfire. If the borrower fails to pay their interest in full or otherwise reduces their debt, it is 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 10% annual interest. This means a $100 payment for the first year.

Now suppose they pay you $50. The remaining portion of the unpaid interest would be added to the principal, or “compounding,” 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. Again, we increase 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 is added to the underlying debt.

Compound Interest vs. Compound Returns

It is very common for articles on this subject to confuse the terms compound interest and compound return. For example, you can 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 yields $100, which you reinvest, leaving you with $1,100 in shares. The following year you will receive another 10% in dividend. Since this is 10% of your new $1,100 portfolio, you will receive $110. Your portfolio is now worth $1,210, giving you a return of $121 the following year, and so on.

This is an example of compounded returns, the growth you make based on growth. Compound returns are similar to compound interest and generally use the same math, which is why many financial sites confuse the two topics. In particular, it is common for financial sites to confuse dividend payments with interest payments. They can lead to comparable portfolio growth, but each concept applies to different underlying assets.

Compound interest applies to payments on a debt-based product because interest applies to payments on a debt.

How to invest in compound interest

SmartAsset: how to invest in compound interest?

SmartAsset: 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 main benefit of investing in compound interest is that, like most debt-based investments, you typically get safe assets. Debt-based products are backed by the credit of the institution behind them. Investment grade assets rarely default, so you usually get your money back. In addition, compounding means that the growth in your portfolio will drive future growth, leading to ever greater profits over time.

The downside is that since it is a relatively safe investment, debt tends to yield less profit than other investments. Your portfolio will grow more slowly with interest payments than with stocks or other higher risk assets.

If you want to invest in compound interest, you should consider a few assets:

High-yield deposit accounts

High-interest savings accounts and money market accounts are probably your most basic form of compound interest investing. These are deposit accounts where you hold money. The bank pays you interest on this account because it uses the money you have on deposit. That interest is added to your account, increasing the value of your account, which in turn increases the next month’s interest payment.

As deposit accounts, both a high-interest savings account and a money market account are FDIC-insured. They tend to pay interest rates between 2% and 4%, depending on the specific account, which is significantly more than many comparable custody options. However, it’s worth noting that even in normal times, this is barely above the Federal Reserve’s target inflation rate, so your profit may break even with the value of money at best.

Deposit receipts

Also a banking product, a certificate of deposit is a kind of super savings account.

When you buy a Certificate of Deposit or “CD,” you put that money on deposit with the bank. You cannot access or withdraw it until the CD is mature without paying a fine. In return, 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 term. The larger your investment and the longer the term, the more interest the bank will pay.

Certificates of deposit pay compound interest. Usually this means they pay you the annual interest that is amortized monthly. 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

Bonds are an investment in debt. When a company or government wants to borrow money, it issues a so-called ‘bond’. These are financial assets that represent part of the institution’s debt. For example, if you own a $500 bond from the U.S. Treasury, it means that the U.S. government literally owes you $500. Each bond has an interest rate that is paid regularly, generally every three months. It also has a maturity date, which is the date the institution repays the face value of the bond.

Suppose you own a $500 bond with a quarterly interest rate of 5% and a term of 20 years. This means that, as the owner of the bond, the underlying institution will pay you $25 every three months. Then, 20 years after the bond is issued, it will pay back the $500 to whoever currently owns the bond.

You can invest individually, by purchasing individual bonds, or in bulk by investing in bond-based ETFs and mutual funds.

Individually paying bonds simple interest. This means that you receive a fixed interest rate based on a fixed underlying principal. However, you can turn it into an effective compound interest by regularly reinvesting your profits. Say you receive $100 in interest over the course of a year. At the end of the year, you can buy another $100 worth of bonds, effectively expanding your underlying principal.

You can do the same in a fund. Your fund may issue yield payments based on the interest your asset has paid. You can use those payments to buy new shares in that fund or another bond-based product. This is generally the easiest way to generate compound interest with bonds, as ETF and mutual fund stocks are typically more liquid than bonds. You can also invest in a fund that automatically uses your profits to buy new debt. Then you will get the same result, only through the administration of the fund.

Property

For most individual investors, the best way to invest in real estate is through a REIT, or “Real estate investment fund.” These are portfolio-based assets that contain various forms of real estate and generate income and returns based on their underlying investments. While many of these are limited to accredited investors, you can find many other funds available to the general public.

When it comes to compound interest investments, this is a partial opportunity.

Many REITs invest in various forms of real estate debt. For the funds that do this, a portion of the portfolio’s total return will be based on the interest payments generated by this debt. As you earn money from those proceeds, you can in turn reinvest it in the fund and buy more shares to increase your total principal share in this portfolio. This will increase your profits over time, in the same way as reinvesting in bonds.

However, this is a diversified form of investing. A real estate investment trust typically generates money from a variety of sources, such as rent and profits from the operation of its properties or the returns it makes from the sale of land. Interest payments will be part of your profit, but not all of it.

It boils down

SmartAsset: how to invest in compound interest?

SmartAsset: how to invest in compound interest?

When you invest in compound interest, you buy a debt-based asset that uses its own growth to continue to 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 serving your area, and you can interview your advisor matches for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.

  • Whatever your time horizon for an investment, it’s important to know where you stand. Smart Asset is free investment calculator can help you estimate how much you will have in 10, 15 or 20 years.

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