The simplest way of explaining compound interest is to call it an interest generated on a previously earned interest. In simple interest, you earn the interest over the principal amount only. However, in compound interest, your wealth increases further because you earn the interest on the principal amount and interest accumulated on it last month, year, week, or even day.
There are different types of investments from where you can earn compound interest. So, given below is a brief discussion of the most common types amongst them.
Savings accounts
The cash that you park in your savings account is lent out by banks and you get an interest added to your account in return. As long as you do not withdraw the funds, you will keep getting the interest added to your account.
Now, you can go for a savings account that allows daily compounding of interest rather than monthly. When interest is compounded that frequently, the account balance increases faster. You can use a compound interest calculator to get a better rate of increase in your account balance.
2. Money market accounts
Money market accounts are a lot like savings accounts, though the former has a higher rate of interest. These accounts also have more liquidity than other options, such as certificates of deposit. But the interest rate is still lower than other types of investments. Thus, although you can still enjoy the benefits of compound interest, you will get better interest rates in other types of investments.
3. Mutual funds
Mutual funds can be a good choice if you are looking for a compound interest investment as a beginner. These funds have professional fund managers who pool money from several investors to purchase bonds, stocks, and other securities. The manager decides on the most profitable way to invest the assets of the fund. So, under an experienced manager, your chances of running into absolute losses are low.
4. Dividend stocks
Dividend stocks can pay compound interest if you keep on reinvesting those dividends. Ask your broker to automatically reinvest each divided payment received and purchase more shares. Do not take the money off the market until you are in serious financial need, and your dividend stocks will keep earning compound interest.
5. Zero-coupon bonds
The risk that comes with having zero coupon bonds is compensated by generating compound interest. In other words, the chance of getting high rewards is made equivalent to the high risks. So, you buy a bond at a major discount, but get no interest payment to hold the bond. You get the face value of the bond when it is due. If the company is unable to repay the full face value, you will stand at a loss.
The bottom line
Each of the five types of investments mentioned above has their own pros and cons. So, you need to consider your risk appetite and financial goals before choosing any of them. Earning compound interest is one of the many factors that you’ll have to keep in mind.
