Compound Interest, Pt. 2 – How to Earn

This is a continuation of our conversation on compound interest. You can read part 1 here.

We previously discussed compound interest and how it is calculated. Now, we will discuss how to take advantage of compound interest. Many people discuss the power of compound interest, which it truly is, but these discussions are useless unless you know how to put your money to work to grow with compound interest. Let’s go over a few examples.

Savings Accounts (low risk)

Savings accounts are the easiest way to take advantage of compound interest. Most banks offer a savings account that allows customers to build their accounts and give monthly interest payments to allow the balance to continue to grow. While it’s great that most bank accounts give consumers this opportunity, most local banks and credit unions have paltry interest rates. According to depositaccounts.com, the average interest rate for savings accounts today is 0.45%. Unfortunately, interest rates these low would make very little impact on one’s ability to make quality returns. A quick internet search for “high-yield savings accounts” can help you find a strong savings account where your savings can get to work building your long-term savings. Finding a savings account that gives closer to 5% in interest is much more powerful than 0.45% and will ultimately make a massive difference. Below is an example of the difference of 0.45% and 5%.

Example 1: 0.45% Interest Rate

Example 1 shows us the growth over 25 years at a 0.45% interest rate, which is the average rate for most savings accounts today. In this case, if you were to deposit $10,000 each year for 25 years, and your interest would be compounded yearly, you would end with $265,165.40. That is $15,165.40 of interest earned over 25 years.

Example 2: 5% Interest Rate

Example 2 shows us growth over 25 years but at a 5% interest rate, which is more common for a harder-to-find, high-yield savings account. With the same parameters, $10,000 deposited each year, interest compounded yearly, the growth difference is staggering. After 25 years, you would end with $501,134.54, which means you would earn $251,134.54 in interest over these years, more than you had initially deposited.

Dividend Stocks (low-medium risk)

Dividend stocks are growing in popularity among investors. These are stock investments where the company pays the investor to invest (you can read more in-depth about dividend stocks here). A good example of a company that pays dividends is Coca-Cola. Coca-Cola has been paying dividends for 50+ years, earning the company the title of dividend king. Most dividend stocks pay the investor quarterly for owning the stock. When an investor earns a dividend, there is a choice to reinvest those earnings into the stock, essentially buying more stocks or cash out the investment. We will go over both examples and see how to use dividends to earn compound interest.

Example 1 – Reinvesting Dividend Earnings

For this example, we will not discuss dividend yields and calculations. Instead, we will use some simple math to make the subject digestible. Let’s say you own 100 shares of a stock that pays a dividend of $2/share owned quarterly. Let’s also assume that the share price is $100 and stays at this price during the whole example (many dividend stock prices do not vary greatly). At the end of quarter one, you will have earned $200 for owning the stock (100 shares x $2). When the funds are reinvested, you will now own two additional shares of this stock, which you will then earn more dividends on in the future. Your next quarter’s dividend payout will then be $204 (102 shares x $2).

Example 2 – Cashing Out Dividends

For this example, we will discuss the same stock used in example 1, but instead of reinvesting the earnings, we will cash them out. After you have earned your first dividend payment of $200, you do not reinvest the payment into the stock, which means you continue to earn exactly $200 each quarter. To earn compound interest, you must make that $200 grow. Otherwise, it is simply a one-time interest payment. You now have many different options. You can invest the $200 earned quarterly into a savings account that earns interest, invest the money into new dividend accounts and earn dividends off of that money, or invest the earnings into other growth stocks or bonds/CDs, which we will discuss below. There are many great ways to earn compound interest off of this money, but unless you put it to use, the compound interest impact will stop.

Growth Stocks (medium-high risk)

Growth stocks are investments in companies that investors look to continue to grow in prices. A few examples of growth stocks are Apple, Microsoft, Tesla, and T-Mobile. These investments do not inherently earn compound interest (unless they have dividends, which many do not), so the responsibility to make the money grow is put upon the investor. Let’s say you purchase two stocks for $100 each and you let the stock grow for two years. At the end of the two years the stock has grown to $350/share, which is a great return.

This means your $200 investment has turned into $700. You can hold onto the stock and hope it continues to grow (which eventually growth stocks slow down significantly after a few years), or you can take the money out and reinvest the earnings. Again, you now need to decide what to do with your money: Will you buy a new stock? Will you put it into a savings account? Maybe a dividend stock? Ultimately, the choice is up to you. Earning compound interest on growth stocks is very doable, but also difficult because you have to have patience to allow the stock to grow, and then have the discipline to sell the stock, not spend the earnings, and then figure out a new reinvestment plan.

Bonds/CDs (low-medium risk)

Generally, bonds and CDs have lower returns than what is possible in the stock market. However, the risks are usually much lower as well (unless you purchase a high-risk bond). Most bonds and CDs allow the consumer to purchase an investment that will pay back interest payments over time or at the end of the agreed-upon end date. Let’s once again use simple numbers and math for this example.

You buy a $1,000 CD that pays a one-time payment of 5% at the end of a year. At the end of the year, you get your principal back, $1,000, and a payment of $50. Again, you have to make moves with your $50 interest to turn this into compound interest, which means you will have to decide how to reinvest the $50.

Time and Funding Accounts are Vital

While we have discussed many ways to earn compound interest, there are a few principles to remember. The first is to be patient. Interest, and especially compound interest, takes time. Do not expect to become rich quickly on compound interest. Instead, expect to put your money to work over several years and earn amazing returns. Second, to truly make a difference, funding your savings can make a life-changing impact. Below are two examples of a simple savings account (earning compound interest): One that is funded, and one that is not.

Example 1 – Funding Your Account

Example 1 is the same example as above, earning 5% interest compounded annually, with $10,000 deposits. For this example, you end with over half of a million dollars, while only contributing $250,000.

Example 2 – Not Funding Your Account

For this example, you put in $10,000 in year one, but do not add any more deposits. You will earn a hefty $23,863.55 in interest, but ultimately, you only end with $32,251.00 over 25 years.

It doesn’t take a Wall Street investor or a banker to understand the power of investing and compound interest. With just a few steps, you can be on your way to building your savings and retirement accounts while taking advantage of compound interest and making your money work for you. If you’re wondering how to get started, first evaluate your risk tolerance and how much money you’re willing to put away for the long term. Again, compound interest takes time and discipline, so if you are not ready to put away money now, that’s okay. After you understand how much money you can put away, find yourself either a high-yield savings account or any of the above savings methods. If you plan to leave your money in a savings account where there is low maintenance, simply deposit your funds, and let the compound interest do its thing (but don’t forget to continue to fund your account)! If you plan to take an alternative route, such as a dividend or growth stock, make a plan for yourself to reinvest your earnings.