How Does Compound Interest Work with Investments?

Graph showing compound interest

The world of investing is a wide one. For some, this is an exciting prospect. But, for others, it can be overwhelming. Regardless of whether you’re a novice or experienced investor, one finance topic you’ll have to understand and work with is the idea of compound interest. With compound interest, your money can serve you in order to help you achieve a secure financial future.

Let’s examine what exactly compound interest is, how it ties in with investment opportunities, and how you can calculate potential returns using a compound interest calculator.

The Mathematical Definition of Compound Interest

Before getting into the nitty gritty of investments with compound interests, it helps to first clearly understand what compound interest is. Compound interest is the interest that’s calculated based on the principal (the initial amount borrowed or invested) in addition to any interest that has been accumulated. This means that you’re facing interest-on-interest, which can either help you grow your savings faster or increase your debt faster. 

For example: If you put $100 in a compound interest savings account that earns 1% interest every year, then at the end of that first year you will have earned $1 (1% of $100). The following year, your balance would be at $101 and the subsequent 1% annual interest you earn is then calculated based on that new amount. That means that at the end of the second year, you would receive $1.01 in interest (1% of $101), resulting in $102.01 in your account. This would go on and on!

Calculating Compound Interest

While the numbers in the previous example are simple enough to work with using mental math, you can also always use a compound interest calculator to figure out how much interest you accrue over a given time period based on your principal/initial investment, interest rate, and compound frequency. A calculator like this is particularly useful if you’re also planning on factoring in additional contributions during the time period. 

Compound Interest Vs. Simple Interest

Compound interest works very differently than simple interest. Simple interest is calculated based solely on the principal amount that was borrowed or invested. Working off the same example as before for comparison, if you put $100 in a simple interest savings account that earns 1% interest every year, you will only ever earn $1 each year, regardless of how much your total has grown since the beginning.

Let’s compare the two in a visual example below, except we’ll use 10 percent yearly return rate to make the difference more pronounced:

Growth of an investment with simple and compounding returns
Growth of an investment with simple and compounding returns, each at ten percent per year
YearSimple Interest Compound Interest

As you can see, with simple interest, the total capital growth is linear, while with compounded interest, the capital growth is exponential. This means that over time, the difference in total capital growth between simple and compounded interest will become significant, which is important when making a decision about investments – or, at least understanding how they work.

The total relative return after ten years is 159% whereas in the other just 100%, or roughly 1/3 less. It is also interesting to note that the difference in total return is not that significant over the first couple compounding periods, but it gets more and more pronounced after each subsequent one.

Which Investments Offer Compound Interest?

Seeing how compound interest works versus simple interest, you can see why compound interest would be particularly beneficial for investments (since your money grows faster by essentially reinvesting the amount you’ve earned so far) while simple interest is often better for loans (since it keeps the amount you owe down). So where do you find these investments that offer compound interest?

As it turns out, there are many different types of compound interest investments! Here are some of the most common: 

  • Certificates of deposit (also called CDs for short) — These offer high interest rates but the money can’t be touched without penalty until the account reaches maturity. Use a CD calculator to explore this more.
  • High-yield or high-interest savings accounts — These will make you more money than a traditional savings account, but you need to factor in inflation rates, which can outpace the amount of interest you’re earning.
  • Bonds (including federal government bonds and municipal bonds) — These come with different levels of risk, and keep in mind that not all bonds pay compound interest.
  • Money market accounts (or MMAs) — These typically earn higher interest than traditional savings accounts and have more liquidity so you can more easily access your money. 
  • Stocks — As the value of a stock is tied to a specific company, the return on your investment can vary greatly depending on what stocks you choose and how the economy is doing.
  • Real estate investment trusts (or REITs) — These are pooled investments that allow you to invest in real estate without having to purchase or manage the properties yourself.

Compounding with Mutual Funds

Mutual funds, which pool money from shareholders/investors to invest in various securities, are yet another option that people turn to diversify their investment portfolio. With these, investors can earn money in different ways, including from dividends, capital gains, selling shares, and more.

Even if you’re not earning a fixed interest with mutual funds, you can reinvest your dividends to earn compound interest. Basically, the more money you put in and the longer you let it stay there, the greater the gains since the returns are “compounded” over time.

Two people standing and looking at an open laptop

Finding the Best Compound Interest Investments

Some people can’t get enough of finance talk and looking for great investments becomes a hobby. Other people may feel confused by all the options out there and remain unsure about how to find the best compound interest investments. If you find yourself in the latter category, you can hire a financial advisor or planner who can offer you personalized investment advice. 

By letting your financial advisor know your money goals (like how much you want to retire with or save by X amount of time), they can create a plan to get you there — not just by investments that match your risk tolerance but also through budgeting, debt management, and more. 

Calculating Compound Interest with Monthly Payments

If you’re in the camp of people who like to dive into the numbers of different investment opportunities on your own, then one of the most useful tools you can employ during your strategizing is a compound interest calculator. By putting together your initial investment amount, the length of the investment contract, the interest rate, the compound frequency (annually, monthly, etc.), and any contribution info, and you’ll get a calculation for the value of your interest, the amount of interest accrued, and your capital growth.

Reaping the Rewards of Intelligent Investing

As you set about planning your financial future, choosing investments where your money is essentially making you money instead of just sitting around and stagnating can help you reach your goals much faster. Part of that is looking into investments with compound interest, which you can weigh with the help of a compound interest calculator. You may be surprised by how much your assets can grow just by compound interest alone!

This entry was posted in Finance, Money and tagged , , , , . By Cindy Brzostowski