Lester Freeman
Compound interest is the interest you earn on interest. In other words, it's when the interest you earn in a savings account or on certain types of investments earns interest of its own. Compound interest has been called the eighth wonder of the world. The idea of compounding motivates many people to start investing. You can earn compound interest by reinvesting interest, dividends and capital gains into your chosen equities, bonds, funds or other assets.
| Characteristics | Values |
|---|---|
| Definition | Interest earned on top of interest |
| How it works | Interest earned in a savings account or on certain types of investments earns interest of its own |
| Types | Compound interest and compound returns |
| Examples | Bonds, certificates of deposit, fixed annuities, dividend stocks, equities, funds |
| Considerations | The sooner money is put to work, the sooner it can start compounding; reinvesting can contribute to compound growth; excessive risk can contribute to large losses, which can erode the long-term effects of compounding |
What You'll Learn
Stocks
When building your investment portfolio, be sure to choose a combination of investments that meet your risk tolerance and long-term goals. Most investors invest in multiple asset classes to spread out the risk.
Compound returns are a broader concept that includes compound interest, but also extends to other types of investment returns, such as dividends and capital gains. This is commonly used in the context of stocks, mutual funds, and other types of investment vehicles.
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Bonds
When it comes to compounding, there are three things to consider. Firstly, the sooner money is put to work, the sooner it can start compounding. Secondly, reinvesting can contribute to compound growth. Thirdly, excessive risk can contribute to large losses, which can erode the long-term effects of compounding.
To maximise the compounding effect, it is best to leave your cash in the market for as long as possible without withdrawing it. This may involve setting aside a separate cash fund for emergencies and unexpected costs.
While stocks are a good investment to compound growth, dividend stocks may be even better. This is because the underlying asset can keep increasing in value while paying out dividends, and this investment can earn compound growth if the payouts are reinvested.
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Certificates of deposit
Compound interest is when interest is earned on top of interest. This is possible with stocks, bonds, certificates of deposit, fixed annuities, dividend stocks, equities, funds and other assets.
CD compound interest is the interest you earn on the interest you've already earned on your principal (your initial deposit). Most CDs compound either daily or monthly. The more frequent the compounding, the more interest your interest will earn. How often your CD compounds is reflected in the annual percentage yield (APY) that the CD's issuer promises when you open a CD. This is the number you should use when comparing CDs.
CDs are a good option if you want to save for a future goal and potentially earn much better returns than a traditional savings account. However, it's important to note that with most CD accounts, there is a penalty for withdrawing money from your CD before it reaches maturity.
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Fixed annuities
Compound interest is when interest is earned on top of interest. This is also known as compound returns.
The earnings in a fixed annuity are tax-deferred until the owner begins receiving income from the annuity. This means that the interest can compound over time. With a fixed annuity, clients can contribute a lump-sum payment or move money into the account over a longer period, such as over their career. Clients can take a payout immediately or defer the payment until later. The insurance company guarantees that the account will earn a certain rate of interest during the period known as the accumulation phase.
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Dividend stocks
Compound interest is the interest you earn on interest. In other words, it is the interest you earn on top of the interest you have already earned. For example, if you invest $100 and receive a 7% rate of return in your first year, your interest has not yet compounded as you are in the beginning stage of the investment. But then, during the second year, you net another 7% return on that same investment. This means your original $100 grows to $114.49, with the 49 cents being the compounded interest earned from the first to the second year.
To maximise the compounding effect, it’s best to leave your cash in the market for as long as possible without withdrawing it. To do this, you might consider setting aside a separate cash fund for emergencies and unexpected costs – ideally, three to six months’ living expenses.
It is also important to remember that excessive risk can contribute to large losses, which can erode the long-term effects of compounding.
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Frequently asked questions
Compound interest is when interest is earned on top of interest. In other words, it's when the interest you earn in a savings account or on certain types of investments earns interest of its own.
Investments with compound interest include stocks, bonds, certificates of deposit, fixed annuities, and dividend stocks.
To maximise the compound interest effect, it's best to leave your cash in the market for as long as possible without withdrawing it. You can also maximise the effect by investing in high-return investments and reinvesting the profits.
