“Interest” is money someone earns by letting someone else use their money. In the case of compound interest, you’re letting that person also use the money your money made by allowing them to keep it for a while longer.
The right strategy can be a very lucrative way to earn passive income.
1. Compound Interest Can Work in Reverse
Compound interest isn’t always a good thing—for you. If you have credit card debt, student loan, mortgage, or personal loan that doesn’t have a 0% interest rate, you’re using the lender’s money and racking up compound interest in their favor.
Trying to earn compound interest on investments while simultaneously paying it, is robbing Peter to pay Paul.
To get the most out of compound interest, plan to pay off as much debt as possible first.
2. Know Your Numbers
Compound interest can be steady and reliable. But you need to know what you’re signing up for by understanding the values for these terms:
- Starting Principal. Your initial investment
- Interest rate. The percentage you earn
- Compound frequency. How often it compounds
- Duration. How long you leave the money to grow
- Additional Deposits. Will you be adding another $10 every paycheck?
Now you can do the math to determine how much your investment will grow.
The formula is: A = P(1 + r/n)nt
But for the rest of us, use a compound interest calculator.
3. Make Sure You’re Getting Compound Interest
Compound interest is interest on the principal + previously earned interest. Simple interest is interest on the principal only.
The magic of compound interest is that you’re earning more money on your earnings, and again, and again.
To ensure this,
- Make sure you’re in an account that offers compound interest.
- Ensure your account is set up to reinvest interest rather than moving into a cash account, sending it to your savings account, etc.
Savings accounts, CDs, interest-bearing checking accounts, money markets, 401K money markets, and bonds have compound interest. Most of these earn minimal interest; in the case of bonds, it only compounds 2X a year.
But as the Federal Reserve raises the interest rate, the rates tied to it go up. You can often lock higher rates for a period if you think the rate might go down.
4. Give It Time
Generally speaking, the longer you’re willing to “tie your money up”, the higher the interest rate and the better the compounding terms will be.
Short-term investments last around 1-3 years. Long-term investments last as long as 20 or even 50 years in the case of retirement accounts. They are the way to go if you can afford to have money that you don’t touch for a long time. In these accounts, your money can as much as double every 5-10 years.
5. Consider Your Risk Tolerance
Generally, the more risk you’re willing to take, the higher your investment’s earning potential. At higher risk levels, they don’t call earnings “interest”. They might call it dividends. But this is just another form interest takes.
The best short-term, low-risk options are:
- Certificates of Deposit
- Treasury bills
- High-yield saving accounts
- High-yield money markets
Shop around to get the best rate and compounding frequency. Don’t expect outrageous growth, but these are good for starters.
The best medium-risk, long-term investments for beginners or those who don’t want to watch their investments constantly include:
- Mutual funds
- Real Estate Investment Trusts (REIT)
Some more advanced, high-risk, and ideally long-term options include:
- Individual stocks Exchanged-Traded Funds (ETFs)
- Buying real estate
- Crowd-funding real estate
- Fine art
- Non-Fungible Tokens (NFTs)
Some of these are risky, and you can lose money rather than make it. But they can help you make compound interest work for you.