Compound interest can help your money grow at an accelerated rate over time. Because of this, it can be a powerful tool in your wealth-building strategy. The secret is to start early and let your account balances grow over time.
Here are seven compound interest accounts (plus real-world examples) to help you grow your money.
- What is compound interest?
- How does compound interest work?
- Types of compound interest accounts
- How to make the most of compound interest accounts
- FAQs about compound interest accounts
- What’s next: Open a high-yield savings account
What is compound interest?
Compound interest is interest that a principal investment and the investment’s previous accumulated interest earn. In other words, it’s interest on interest.
Image: what-is-compound-interestFor example, a $1,000 investment that compounds annually at 5% for three years would compound as follows:
Year 1: $1,000 + 0.05 x $1,000 = $1,050
Year 2: $1,050 + 0.05 x $1,050 = $1,102.50
Year 3: $1,102.50 + 0.05 $1,102.50 = $1,157.62
Notice how every compounding period generates an increasing amount of interest. Let’s go over why.
Image: power-of-compounding-interestSimple interest vs. compound interest
Simple interest and compound interest differ in how they generate interest and their rates of return.
Simple interest allows you to generate interest on a principal investment only. When left alone, simple interest will grow your money at a constant rate.
Take the $1,000 investment mentioned above. Here’s how it would grow if it were generating 5% simple interest rather than compound interest:
Year 1: $1,000 + 0.05 x $1,000 = $1,050
Year 2: $1,050 + 0.05 x $1,000 = $1,100
Year 3: $1,100 + 0.05 x $1,000 = $1,150
Unlike simple interest, compound interest earns interest on both a principal investment amount and its accumulated interest — which steadily increases. These additional earnings allow your money to grow at an accelerated rate.
Image: simple-vs-compound-interestHow does compound interest work?
Compound interest works by allowing a saving’s accumulated interest to earn interest on itself. The compound interest formula is:
P(1 + R/N)^NT = A
- Final amount: In the formula above, “A” represents the final investment amount. This includes the initial principal plus the compounded interest.
- Principal: Represented by “P,” the principal is the initial investment amount.
- Rate: “R” is the interest rate associated with the investment.
- Number: “N” is the number of compounding periods per time period.
- Time: “T” is the number of time periods.
Let’s say you invest $10,000 in an account with 4% interest compounded monthly. To see how much your uninterrupted investment would grow after 10 years, you would use the following calculation:
$10,000(1 + .04/12)^(12 x 10) = $14,908.30
If you need help estimating how compound interest will impact your investments, you can always use Credit Karma’s compound interest calculator.
Types of compound interest accounts
While the best compound interest account for you will depend on your financial situation and goals, you have several options. Here are a few types of accounts that can earn compound interest and some examples of each to help you get started.
High-yield savings accounts
High-yield savings accounts function the same as typical savings accounts — they simply come with a label designating that they pay a “high” amount of interest. While no regulation states how much interest qualifies as “high-yield,” the average savings account was yielding around 0.46% in December 2023, so investors could consider anything above that as high.
While high-yield savings accounts could be a good option for saving money that would otherwise simply be sitting — like an emergency fund — they may not the best option for more aggressive investing.
- Example: Quontic Bank high-yield savings account (compounds daily)
- Annual percentage yield: 4.5% APY as of January 2024
Money market accounts
Money market accounts are similar to high-yield savings accounts in that they typically have higher interest rates than standard savings accounts. They differ because money market accounts allow you to write checks and make debit purchases. If you want both the benefits of a savings and a checking account, a money market account could be the way to go.
- Example: Discover money market account (compounds daily)
- Annual percentage yield: 4.2% as of January 2024
Certificate of deposit (CD) accounts
If you’re a new investor looking to grow your money over time, certificates of deposit (CDs) can be a great option. According to the U.S. Securities and Exchange Commission, CDs are one of the safest savings options available.
A CD is an account where you deposit a lump sum of money for a specified period. CDs generally offer higher interest rates than savings accounts and typically compound daily or monthly. The only catch is that you usually cannot withdraw the money before the specified period ends; otherwise, you may face early withdrawal penalties.
Many banks and credit unions offer CDs, so check with your local financial institution if you’d like to start investing, or check out the options below.
- Example: Charles Schwab
- Annual percentage yield: 5.06% for a six-month CD in January 2024
Daily compound interest accounts
Daily compound interest accounts are just what they sound like — accounts that compound interest on a daily basis versus monthly, quarterly or annually. Because of their increased compounding frequency, these accounts can grow your money at faster rates compared with similar accounts that compound less frequently.
Daily compound interest accounts can come in several different forms — certificate of deposit accounts, high-yield savings accounts or money market accounts, for example.
- Annual percentage yield: varies by account type (savings, money market, or CD)
- Example: Ally high-yield CD account (compounds daily)
Real estate investment trusts (REITs)
Real estate investment trusts (REITs) allow you to invest in real estate without having to purchase a property outright. Instead, you can purchase shares in a company that holds real estate, which will then issue dividends to shareholders.
As with stocks and bonds, reinvesting REIT dividends can provide the benefits of compound interest.
- Average annual yield: varies by fund
- Example: Vanguard real estate index fund, with dividends reinvested
Bonds and bond funds
Bonds are similar to an IOU. When purchasing a savings bond, you are essentially loaning money to the issuer. In exchange, the issuer promises to pay you a set interest rate during the bond’s life and repay the principal (purchase price) at the end of the term.
Bonds come with varying degrees of risk. High-yield bonds have a lower credit rating, which implies higher risk. To offset this risk, high-yield bonds also offer higher interest rates. U.S. Treasury bonds are backed by the U.S. government, making them a safer investment, although the interest rates may not be as high as other options.
To receive the benefits of compound interest when purchasing bonds, you might consider reinvesting the interest you earn.
- Example: U.S. Treasury bonds, with interest reinvested
- Rates vary by issue date: 4.750% as of January 2024
Dividend stocks
Dividend stocks are stocks that pay out regular dividends — part of the company’s profits — to investors. Similar to bonds, reinvesting the dividends from stocks can provide the benefits of compound interest.
Additionally, dividend stocks average higher returns than savings accounts, CDs, money market accounts, real estate and bonds. This makes dividend stocks a potentially worthwhile option for those looking to grow their money more aggressively.
Want to invest in dividend stocks but aren’t sure where to start? Check out the “dividend aristocrats,” which is a group of stocks in the S&P 500 with more than 25 years of consecutive dividend increases.
- Example: Dividend Aristocrats, with dividends reinvested
- Average annual rate of return for dividend payers: 9.18%
How to make the most of compound interest accounts
When using compound interest accounts, following a few best practices can help you receive the maximum benefits: Start as soon as possible and stay invested (do not withdraw money).
Image: tips-to-make-most-of-compound-interestBecause compound interest offers increasing returns over time, the more time you have, the better. For example, consider again $10,000 invested in an account with 4% interest compounded monthly. In five years, this investment would become $12,209.97. In 10 years, it would become $14,908.30.
The above example assumes one other tip when using compound interest: stay invested. Uninterrupted compound interest accounts will continually increase the amount of interest-generating money. Withdrawing money will decrease this amount, which will decrease your overall returns.
While making withdrawals from time to time may be necessary, try to avoid it whenever possible.
FAQs about compound interest accounts
Have other questions about compound interest accounts? Here are answers to some commonly asked questions.
Common accounts that can generate compound interest include certificates of deposit (CDs), savings as well as money market accounts. You can also use the power of compounding by reinvesting the interest or dividends earned on bonds, stocks and real estate investment trusts (REITs).
Compound interest can help you build wealth, but not quickly since its benefits increase over time. The longer you stay invested, the more benefits you will see.
To help estimate when your investment will double, you can use the Rule of 72. Simply divide 72 by the return rate on your account. So, for a $10,000 investment with a 4% return rate, you would calculate 72/4 = 18, meaning it would take about 18 years for your investment to become $20,000.
Many banks and credit unions offer compound interest accounts in the form of a savings account, money market account or certificate of deposit (CD) account. Check with your local financial institution to see what compounding accounts they may offer.
It’s not typical to lose money with a compound interest account. However, if the account comes with penalties for early withdrawal, it may be possible to lose money.
For example, some CDs come with early withdrawal penalties. Depending on the penalty, it could amount to more than the previously generated interest. In this case, you would need to use part of the principal in the account to pay the fee, resulting in a net loss.
What’s next: Open a high-yield savings account
If you’re looking to grow your money with a compound interest account, consider opening a high-yield savings account like Credit Karma Money™ to help you stay on top of your savings goals.
Sourcing
- CDs are one of the safest saving options. Certificates of Deposit (CDs).
- Average bank rates on different types of accounts. National Rates and Rate Caps.
- U.S. Treasury bonds are a safe investment. Bonds.
- Dividend paying stocks average a 9.18% rate of return. The Power of Dividends: Past, Present, and Future.