29 Jan THE POWER OF COMPOUND INTEREST
Steps Required to Open a Compound Interest Account
Each company has its specific process for how to open a savings account with compound interest. Here is a general overview of how this works and what you should consider as you compare your options.
Step 1: Determine the type of compound interest account you need. Start by deciding what type of compound interest account you’d like. Do you want to earn a guaranteed return where you can’t lose money? You may be better off with a bank offering high-yield savings accounts, money market accounts, and certificates of deposit (CDs).
Or would you like to invest for a higher compounding rate, even if there’s a risk of short-term losses? Then you would want a brokerage account to invest in bonds, mutual funds, REITs, and stocks. You may find a company that gives you a combination of both. For example, Fidelity allows you to invest in the market while also paying a guaranteed interest rate on your uninvested cash.2
Step 2: Compare costs, fees, and incentives. Each compound interest account has its own set of costs and fees. Some fees you could run into include:
- Annual account fees: A compound interest account could charge a flat fee annually.3
- Minimum account balance fees: Financial institutions often charge a monthly fee if your balance isn’t large enough. For example, you need at least $500 in your account, or you owe this fee.4
- Trading commissions: Investment brokers could charge a commission every time you buy and sell assets for your compound interest account.
- Expense ratios: If you’re investing in funds managed by a professional, the fund could charge an expense ratio as a percentage of your investment.
The more you pay in fees, the less you earn overall. The best compound interest accounts keep these as low as possible. Companies may also offer incentives when you open a new compound interest account. For example, you receive a $200 bonus for opening a savings account. Check for these as well to get a jump start on growth.
Step 3: Compare services. Not every company offers the same services. Think of what you’d like from your compound interest account in these categories:
- Product selection: There are many ways to earn compound interest. Each financial institution provides a different product selection. Consider how you want to save or invest and ensure the option is available.
- Access to a variety of investment accounts: You could earn compound interest through a regular bank account or investment account. You could also save through tax-advantaged retirement accounts called individual retirement accounts (IRAs) as well as college savings plans. Consider your financial goals and make sure the right accounts are available.
- Compound interest calculators and other online resources: A compound interest calculator shows how much your money could grow over time. Companies may provide other free financial tools to plan your budget or see if you’re on track for retirement. Some provide extensive educational materials.
- Access to brick-and-mortar branches: Do you want to get help in person, or are you OK handling everything remotely? Some compound interest accounts offer brick-and-mortar branches, while others do not.
- Customer service options: Companies have different service options like phone, email, and live chat. They also have different service hours. See that a company offers what you want.
- Support from a financial advisor: If you’d like support from a professional, some companies offer access to in-house financial advisors. Others leave you to plan on your own.
Step 4: Sign up for an account. Once you’ve decided where to open your compound interest account, you can formally sign up. You must provide your personal contact information, employment information, and tax ID number, usually your Social Security number. The institution needs to verify your identity to meet government regulations.5
How long the application process takes depends on the type of account. You could potentially open and qualify for a bank account within an hour.6Brokerage investment accounts can take as long as several days, as the broker must review your application and financial information.5
Step 5: Fund your account. Last, link your current bank account to the compound interest account so you can transfer money in. Once you’ve set up the account along with any investments, you’ll start growing your savings with compound interest.
What is compound interest?
For savers, the definition of compound interest is basic: It’s the interest you earn on both your original money and on the interest you keep accumulating. Compound interest allows your savings to grow faster over time.
In an account that pays compound interest, such as a standard savings account, the return gets added to the original principal at the end of every compounding period, typically daily or monthly. Each time interest is calculated and added to the account, it results in a larger balance. With the compound interest formula, the account earns more interest in the next compounding period.
For example, if you put $10,000 into a savings account with a 4% annual yield, compounded daily, you’d earn $408 in interest the first year, $425 the second year, an extra $442 the third year and so on. After 10 years of compounding, you would have earned a total of $4,918 in interest.
But remember, that’s just an example. For longer-term savings, there are better places than savings accounts to store your money, including Roth or traditional IRAs and CDs.
Compounding investment returns
When you invest in the stock market, you don’t earn a set interest rate but rather a return based on the change in the value of your investment. When the value of your investment goes up, you earn a return.
If you leave your money and the returns you earn are invested in the market, those returns compound over time in the same way that interest is compounded.
If you invested $10,000 in a mutual fund and the fund earned a 6% return for the year, it means you gained $600, and your investment would be worth $10,600. If you got an average 6% return the following year, it means your investment would be worth $11,236.
Over the years, that money can really add up: If you kept that money in a retirement account over 30 years and earned that average 6% return, for example, your $10,000 would grow to more than $57,000.
In reality, investment returns will vary year to year and even day to day. In the short term, riskier investments such as stocks or stock mutual funds may actually lose value. But over a long time horizon, history shows that a diversified growth portfolio can return an average of 6% annually. Investment returns are typically shown at an annual rate of return.
Compounding can help fulfill your long-term savings and investment goals, especially if you have time to let it work its magic over years or decades. You can earn far more than what you started with.
What You Need to Open a Compound Interest Account
You must submit a variety of personal and financial information to open a compound interest account. Financial institutions need this information to report your tax earnings and meet other government regulations (like anti-money laundering.) So expect to provide the following.
- Home address (you may need to provide proof, like a utility bill or mortgage statement)
- Contact information, like your phone and email address
- Date of birth
- Social Security number
- Driver’s license, passport, or another form of government ID
Financial and Investment Information
If you’d like to earn compound interest by investing, you must provide more financial information beyond a basic bank account. The broker needs this information to determine which investment options and strategies are appropriate for you. You may need to provide the following:7
- Employment status and occupation
- Annual income
- Net worth
- Risk tolerance for losing money
- Investment goals and objectives
Understand the Basics
If you’d like to start earning compound interest, you need to decide on the type of account. There’s a broad range of compound interest accounts. You can choose from very safe, basic accounts that take very little research. You could also focus on more complicated, higher-risk accounts with higher possible returns. Here are the more basic, safe compound interest accounts and what they involve.
High-Yield Savings Accounts
High-yield savings accounts are bank accounts paying a high interest rate. The best high-yield savings accounts pay a highly competitive return with very low fees; most are free. You can’t lose money in a savings account, and savings accounts give you convenient access to your money at any time. If you’d like to learn more about high compound savings interest accounts, see our roundup of the best high-yield savings account rates.
Money Market Accounts
Money market accounts are another bank deposit account. They typically have a higher minimum balance requirement than high-yield savings accounts. Otherwise, you owe a monthly fee. In exchange, money market accounts usually pay a higher interest rate. So if you’re willing to deposit more money, you can earn more compound interest using a money market account. These accounts have a guaranteed return and you cannot lose money. You can also withdraw whenever you want.
Certificates of Deposit (CDs)
When you sign up for a CD, you pick how long it will last (the term). It could range from a month to many years. During this time, you earn a guaranteed compound interest rate. Your balance is also insured, so it won’t drop. However, you will owe a penalty if you want your money back before the end of the agreed term. If you take money out early, you could forfeit interest earnings and even some of your deposit. CDs typically pay a higher interest rate than other bank deposit products in exchange for giving less access to your money.
Bonds and Bond Funds
With a bond, you’re lending money to a government, company, or other organization for a set period. During this period, you receive interest, and you get your money back at the end of the bond term.
Bonds have more risk and take more research than bank deposit accounts. First, you must check how safe a bond is by checking the issuer’s credit rating. If a bond issuer runs into financial trouble, it might not pay all the interest or even fail to pay you your deposit back. To stay safe, consider bonds from issuers like the U.S. government or very large, established companies. Bond rating agencies give letter grades to show the financial stability of different bond issuers.
If you want your money back before the end of the bond term, you could sell to another investor through your investment platform. However, you might get back less than you paid. This happens if interest rates have increased since you first bought the bond.8
. “Bonds, Selling Before Maturity.”
If you don’t want to put in the research and work yourself, another option is to buy a bond fund. A professional investor builds a portfolio of different bonds so you can earn compound interest this way.
Mutual funds combine the money of many small investors to create a large investment portfolio. A professional investor manages the portfolio to decide on the investments. Each mutual fund has different investment objectives. For example, an income mutual fund would focus on bonds and other safer investments, while a growth mutual fund would focus on higher-risk but higher-earning investments like stocks.
There is more risk with mutual funds. The investments may not work out, and your balance could fall. However, mutual funds have higher earning potential than bank accounts. If you’re investing long-term, you could potentially earn more compound interest using mutual funds.
Types of High-Risk Compound Interest Accounts
These compound interest investments can earn more than the basic options if you want to push for a higher return. But, be warned, they also require more research and you have a higher risk of losing money.
Real estate investment trusts (REITs) are funds that invest in real estate. You pool your money with many other investors. Then, the REIT uses this money to build a portfolio of properties. You earn a share of the profits from rent and property sales. It’s a way to make compound interest from real estate without going through the work and high expense of buying your own properties. Many REITs are publicly traded so you can sell to another investor and cash out at your convenience. However, non-traded REITs lock you in potentially for years.9
With bonds, generally, the riskier the investment, the higher the interest rate. High-yield bonds, or junk bonds, pay a higher face interest rate. As a result, you earn more in compound interest. However, high-yield bonds have an increased risk of default. As a result, you might only get some of the interest payments. If the issuer goes bankrupt, you may also lose your initial investment. High-yield bonds are those with a Standard & Poor’s credit rating of BB+ or worse.10
Cryptocurrencies, like Bitcoin and Ethereum, are a type of digital currency. Cryptocurrencies are decentralized and not managed by any government. If you invest in cryptocurrencies, you could make money if the price goes up. Some cryptocurrencies also use a system called staking. If you own the cryptocurrency, you could agree to lock it up temporarily and earn an interest return paid in more cryptocurrency.11 Cryptocurrencies are another very high-risk, potentially high-reward investment.
Companies issue stock to raise money. When you buy stocks, you become a part owner of a company and could share in future profits. When a company makes money, it can either reinvest to continue growing or pay out earnings to shareholders through a dividend payment. Dividend stocks come from companies paying a higher dividend rate. These are usually larger, more established, profitable companies. Smaller companies and those trying to grow are less likely to pay dividends.
If you want compound interest from dividend stocks, research the past dividend rate of each company. Confirm that a company will remain profitable so it will keep paying. For ideas, check out these top dividend stocks. If you don’t want to do this work yourself, you could look for a mutual fund focused on dividends.
Alternative investments are those outside the conventional financial markets. These could include hedge funds, private equity funds, commodities, artwork, and farmland. Alternative investments are higher risk and require more research. Some, like hedge funds, require you to be an accredited investor. In exchange, these investments could also earn high returns.
Compounding with additional contributions
As impressive as compound interest might be, progress on savings goals also depends on making steady contributions.
Let’s go back to the savings account example above and use the daily compound interest calculator to see the impact of regular contributions. We started with $10,000 and ended up with $4,918 in interest after 10 years in an account with a 4% annual yield. But by depositing an additional $100 each month into your savings account, you’d end up with $29,648 after 10 years, when compounded daily. The interest would be $7,648 on total deposits of $22,000.
Factors That Affect How Much Interest You Earn
Predicting your compound interest earnings lets you see whether you’re on track for your goals. Some of the factors that determine how much you’ll earn include:
As the saying goes, it takes money to make money. Therefore, the more you deposit into a compound interest account, the more you earn annually. This is the foundation of interest compounding. As you build your savings from the compound interest, you will make more and more per year.
An account interest rate shows how much you will earn per year on your balance. When researching how to open a compound interest account, look for one offering a competitive rate. You should also keep an eye on market and economic changes. Rates change, which could increase or decrease how much interest you earn per year. You should also check regularly to see if you could get a better deal from another company.
Compounding frequency is how soon your account starts earning interest on prior earnings. Accounts could compound annually, quarterly, monthly, and even daily. The more frequent the compounding schedule, the more interest you earn per year. This is because the account starts paying a return on your past earnings sooner. If you’re wondering how to open a daily compound interest account, our review of the best CD rates identified many that do just that.
If you owe fees for your compound interest account, they will be deducted from your balance. Therefore, the more you pay out in fees, the less you keep for your annual interest earnings for compounding.
How Does Compound Interest Work?
Compound interest works by growing your money through a bank or investment account. You first put your money into a compound interest account. It says how much you will earn per year. Your balance then grows by this compound interest amount. The following year, your balance plus interest earnings will continue to grow by the return. Compound interest works exponentially because you earn more and more as your savings grow.
Who Benefits From Compound Interest?
Savers and investors benefit from compound interest. You need to have extra money to put into a compound interest account. Then, it will generate a return to grow your savings. As you build your account balance, you earn more each year thanks to compounding.
On the other hand, compound interest hurts people in debt. If you owe interest, the amount gets added to your outstanding balance. So the more you owe, the more you’ll be charged in interest each year, increasing how much you need to pay back.
Are Compound Interest Accounts Safe?
Many compound interest accounts are safe, such as high-yield savings accounts, money market accounts, and CDs. Banks guarantee your return and you do not face market losses in these accounts. Safe compound interest accounts tend to pay a lower interest rate, however.
If you want to earn more, you could put your money into riskier investments like dividend stocks, mutual funds, and REITs. If the investment does well over time, you earn more yearly with compound interest. However, you also have the risk of losing money.
How Is Compound Interest Calculated?
Compound interest for one year is calculated by multiplying your starting amount by one plus the interest rate. If you have $1,000 and earn 5%, your growth with compound interest equals $1,000 x (1 + 5%) = $1,000 x 1.05 = $1,050. For multiple years, use this formula: starting principal x (1 + interest)^n, where n equals the number of years. In this same example, your $1,000 would turn into $1276.28 over five years.
This formula works with annual compounding. If you compound more frequently, it gets more complicated. You could use an online compound interest calculator to determine how much you will earn over time.
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