What is Compound Interest?
To put it simply, compound interest is the interest you earn on interest. For example, let’s say you invest $100 and it earns five percent interest each year. You’ll tally up $105 at the end of the first year.
A simplistic example, for sure, but compound interest in a nutshell means your money will make more and more money over time. Compound interest might serve as one of the most amazing money makers in the history of the world.
You want in, right? Learn more about how you can make compound interest work for you.
How Compound Interest Works
Compound interest happens when interest gets added to the principal amount you invest or borrow, then the interest rate applies to the principal as it gets larger. Compounding works both for and against you, depending on whether you’re saving and investing (works for you) or paying off debt (works against you).
How Can I Earn Compound Interest?
Compound interest is a powerful force, so take a look at the steps you can take to make it happen.
Step 1: Put money in a situation where it will gain interest.
Needless to say, stuffing cash under your mattress won’t get you anywhere. You can’t compound your money if your cash doesn’t see the light of day. The earlier you can put your money to work, the more you can expect to have later down the road. That means consider right now where you want to put your hard-earned cash.
Step 2: Add time.
Your next ingredient: Time. That begs the question: How much time do you need for compound interest to do its thing?
Great question! The Rule of 72 offers an easy compound interest calculator. You simply divide 72 by your investment’s interest rate to determine how your money will perform. For example, It will take 14.4 years for your money to double with a five percent interest rate. (You might have some fun figuring this out if you already own a few investments.)
In other words, give your money a chance to grow!
Step 3: Play around with a compound interest calculator.
If you want to understand how other factors play into your money’s growth rate, look at a compound interest calculator, which takes other factors into account, such as your monthly contribution rate, interest rate variance range and more. The investor.gov website has a great compound interest calculator you can use.
Step 4: Figure out how much money you need for the future.
The compound interest calculator will help you figure out how to benefit the most from compound interest but it’s a good idea to actually apply that figure to real life. Help yourself understand how much you need to save and at what percentage you need to earn interest to have enough money for your future goals, such as retirement and college savings.
Let’s say you have a goal to save for college. Follow these steps!
- First, take a look at Vanguard’s College Savings Planner Tool and punch in the numbers applicable to your child’s age, age starting college, years attending college, current college annual cost (you could use your alma mater just to make it simple), your planned contribution and your savings amount right now.
- Contrast the total amount you calculate with the Vanguard College Savings Planner Tool with what you currently save.
- Determine whether your current savings rate is enough to fund your child’s college education. Adjust your planned contribution or your interest rate to figure out where you will fall short.
- Implement an action plan so you save enough — or in some cases, you might have enough left over to transfer to another family member!
Step 5: Let UNest help you build compound interest.
Let UNest help you build compound interest and tax-free growth — a double bonus! You can contribute however much you want to contribute each year, no matter how much money you make, whether you make $40,000 per year or $400,000 per year.
How do you build compound interest with UNest? UNest offers age-based investment options, which allows principal and interest to build, particularly when your start your child’s account as soon as he or she is born.
What Kinds of Investment Products Earn Compound Interest?
Beyond 529 plans, what other types of investments earn compound interest?
Type 1: Retirement Accounts
401(k)s and IRAs offer low-to-moderate risk investment options that grow over time and certainly compound and build until you take your money out in retirement.
- You get a 401(k) through your employer. Have you started a 401(k) through your employer? If not, do so immediately so you can take advantage of compound interest. A 401(k) works when you elect to take money out of your paycheck to fund your retirement account. Some employers even offer a matched contribution, which means that they put money in your account as long as you put money into it, too. Take advantage of this free money!
- You can open an IRA through a brokerage. You may have heard of Traditional IRAs and Roth IRAs, and a few nuances exist between the two. Traditional IRAs do not get taxed until you withdraw your money after retirement.
On the other hand, you add to your Roth IRA using post-tax income, so you won’t have to worry about taxes when you withdraw your money during retirement.
In both cases, compound interest grows your money. Start as early as you can, because saving $5,000 every year from age 22 can easily make you a millionaire, as long as you take advantage of its effects.
Type 2: Stocks
Stocks absolutely reap the benefits of time and compound interest. If you reinvest your stock dividends (earnings on the stocks you own) and reinvest them into more stock, these shares grow and give you more dividend payments. (Think of them multiplying like bunnies.) Your portfolio will grow even faster, with the help of compound interest.
A $20,000 investment that earns six percent a year grows to $66,204.09 compounded monthly over 20 years. If you can increase your return to 10 percent, the amount you earn grows immensely, to $146,561.46.
Naturally, you want to try to invest stocks that offer high returns and keep them for the long term!
Type 3: Savings Accounts
Savings accounts also offer an opportunity to compound because they offer you interest. Savings accounts often offer higher than interest you can earn on checking accounts. You can also earn compounded interest in money market accounts and certificates of deposit (CDs).
Remember that bank accounts will not compound to the degree that other investments will (like stocks) because of their low interest rates. Carefully consider whether you want to keep your money in a savings account if you have growth in mind.
Type 4: Bonds
Some types of bonds also offer compounded growth. Let’s focus on zero coupon bonds, which you pay less for than face value. For example, you may pay just $9,500 for a zero coupon bond instead of paying the face value, at maturity, you’ll collect $10,000. The $500 difference makes up the compounded value of interest payments.
Again, bonds will not compound to the degree that other investments, like stocks, compound.
Get Compound Interest Working for You — Especially When You Save for College
You don’t want to feel lost in the dust when you save for college, and if you don’t get compound interest working in your favor early on, you might not save enough. Play around with some compound interest calculators, college savings calculators and then put that newfound knowledge into investing with UNest.
Open an account by adding the following information for both you and your child:
- Legal name
- Date of birth
- Social Security Number or ITIN
- U.S. citizenship or legal residency information
- U.S.-based personal bank account
Finally, contribute the minimum amount of $25 per month. The more you contribute, the more you’ll reap the benefits of compound interest over time. You’ll find yourself shopping for dorm room knick knacks before you know it!