How to use compound interest investing to retire rich.
How does a housekeeper save hundreds of thousands on almost no income? What’s the investment that will grow your money whether you’re starting with $10 or $10,000?
In this video, I’m revealing the power of compound interest investment. I’ll not only show you what compound interest means but will reveal three investments you can use to grow your dough fast.
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The Real Power of Compound Interest!
We hear about compound interest and maybe even have seen it a little in our bank accounts but few people know the real power of compound interest investment.
It’s just hard to get excited about $0.35 interest in a savings account.
Oseola McCarty had a slightly different perspective.
Oseola was born in Mississippi in 1908. She spent the better part of her 91 years washing clothes for others, living in the same house for almost 75 years and saving her money.
Now even living the frugal lifestyle, the money made from doing other people’s wash isn’t the kind of job that makes you rich but in 1995, Oseola donated $150,000 to the University of Southern Mississippi and still had more than a hundred grand in the bank.
You CAN get rich on any income and THAT’S the power of compound interest investing.
What is Compound Interest?
In this video, I’ll explain compound interest and walk you through the formula. We’ll talk through a couple of examples and then I’ll reveal three of the best investments to make money on your money.
We’re not talking about growing your bank account by a few pennies each month. I’ll be showing you three investments with compound rates upwards of 10%…the kind of interest that WILL grow your money fast.
But what is compound interest? Einstein called compound interest the “greatest mathematical discovery of all time.” I just call it the easiest way to financial freedom.
Compound Interest Explained
Here’s the formula for compound interest but don’t let the math fool you. This is one of the easiest ideas to understand.
Compound interest is just your money times an interest rate and how long you let it grow…but it’s that time factor that’s the real power here because you don’t just add the interest you earn every year onto your money.
Compound interest is about making your money work for you. It’s the money you make on that interest.
How compound interest is calculated
You may still be thinking that compound interest is this complicated topic that you may never actually utilize because it’s just too hard. Well actually, compound interest uses a very simple equation that anyone can learn! In the following paragraphs I will dissect each part of the equation that represents compound interest below to help you better understand the basis of it.
The mathematical formula for compound interest is as follows:
Now let’s break it down:
Each letter in this equation is referred to as a variable and they each have a specific role.
A = Final Amount
P = The Principal Amount
r = The Interest Rate Expressed (decimal)
n = The Compounding Frequency
t = The Time Period (years)
Now what do each of those actual mean?
A: This A being the final amount is simply what we are searching for.
Principal: A principal amount is just another way of saying the initial or starting amount. For example, if you decided that you were going to invest $5000 for 5 years, your principal or ‘starting’ amount would be $5000.
Rate: The rate is referring to the interest rate or expected rate of return when investing. This number will always be expressed as a decimal. For example, if you were expecting that your investment was set to grow by approximately 8% per annum, your ‘r’ would be 0.08.
Compounding Frequency: Compounding frequency is referring to how frequently you add interest to your principal amount. So, you first need to know, are you using annual compounding, semi-annual compounding, quarterly, weekly, or daily compounding? If you were using annual compounding, and the interest rate was 8%, you would simply add 8% to your principal amount every year. If you were using semi-annual compounding, the 8% would be cut it half, because it would now be distributed twice a year. So now, you would be adding 4% to the principal twice a year.
Time: Time is an easy one Time is quite literally referring to the time in years you are making the investment for. For example, if you plan on making the investment for 18 months, you will write 1.5 (years).
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Compound Interest Example
Let’s look at an example here. You start with a $1,000 investment making 5% a year. After that first year, you’ve made 5% so an extra $50 in your account.
Now that second year, you make another 5% on your original thousand dollars but you also make 5% on the $50 you earned in the first year. That means you make $52.50 in the second year.
An extra $2.50 isn’t something most people would get excited about but look at how that money grows. At the end of six years, you have $340.10 more in the account. That’s $40 more in compound interest, forty-bucks extra you made off the interest.
Take it out further and over 30 years you’d have $4,322 in the account. You’d earn just $1,500 in that annual $50 interest but over $2,800 on the compound interest returns!
And that’s on a relatively low 5% interest rate. That’s about what you’ll earn on bonds but take this further with an 8.5% compounding return in stocks or some of the investments I’ll show you later and watch your account explode. Just that 8.5% compounding return on stocks would mean over $10.500 in stocks over 30 years, all from one single thousand-dollar investment.
How Do I Get Compound Interest?
Another question I get a lot is just, “How do I get compound interest?”
So you get compound interest in any investment or account that pays a return and you leave the money in your account to grow. And the great thing about compound interest is that it works on any amount of investment, whether you’re starting with $10 or $10,000!
Now banks do offer compound interest, but how much are you making on the average 0.1% savings rate? Even the 2% interest from some online banks is barely keeping up with inflation.
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This is actually how Oseola made a lot of her money and God bless her, she grew an amazing fortune on those savings but even her advisor has said that she would have been a millionaire if they had started compound interest investing sooner.
Best Compound Interest Investments
What I want to do is show you three compound interest investments you can use to grow your money faster.
First though, a feedback question for the community. What other personal finance concepts do you want to see covered here on Let’s Talk Money? We’re talking those day-to-day financial decisions like buy vs rent and are credit card rewards programs worth it. Scroll down and let me know in the comments, what personal finance questions do you want answered.
Now on to those three compound interest investments and the next step up from a savings account is going to be bond investing.
Bonds are debt issued by companies or governments, paying interest twice a year and then returning the amount borrowed to investors at the end of the loan. So you get that regular interest payment that compounds twice a year and you can get rates of four to six percent on some fairly safe bonds.
You can invest in individual bonds or go with my favorite, get thousands of individual bonds with one fund like this iShares High Yield Corporate Bond ETF, ticker HYG. This fund pays a 5.3% yield and has actually produced a total return of 7% over the last decade, so that means you would have made money on the share price as well.
The bond fund is well diversified across the major sectors and a little overweight in the safer sectors like telecom and consumer goods so you don’t have to worry about defaults from a particular sector.
To see the power of compounding in this bond investment, look at how just $200 a month grows over 30 years. On just $72,000 invested over those three decades, you’d end up with more than a quarter million dollars.
That’s over a $150,000 profit in compounded returns and what I want you to notice in this chart is that the line gets steeper over time. That’s the power of compounding interest. If we were to let that line run 40 or 50 years, it would be going almost straight up earning so much money every year.
Dividend Stocks for Compound Interest
Those of you in the community knew I couldn’t get through a whole video without talking about dividend stocks. Besides paying that consistent cash flow every quarter, dividend stocks just beat the market with amazing long-term returns.
We’ve been beating the overall market with our 2019 Dividend Portfolio of individual stocks but for this video, I wanted to look at an easy, no-stress dividend fund for those compound returns.
The Schwab US Dividend ETF, ticker SCHD, pays a 2.9% yield and charges one of the lowest expense ratios you’ll see at just 0.06% a year. The fund holds shares of some of the best and biggest dividend payers like Intel, Proctor and Gamble and Coca-Cola.
Now that 2.9% dividend yield may not sound like much but this fund has produced a 10.2% annualized return over the last five years. Taking our example of investing $200 a month over 30 years and that becomes nearly $410,000 in your account.
That’s a profit of over $337,000 on your $72,000 invested over the three decades, more than twice what compounding returns made you on the bond fund.
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P2P Loans for Compound Interest Investment
Our next compound interest investment is a controversial one, but stick with me because I’m going to show you how to get nearly 10% cash flow to grow your money.
Peer-to-peer lending is just like bond investing except you’re lending money to people rather than big corporations or governments. Borrowers fill out an application on sites like Lending Club and investors choose which loans they want to fund.
Borrowers make a monthly payment of principal and interest which Lending Club collects and automatically sends to any investors in the loan.
Now the risk is higher in p2p versus that bond investment we saw earlier. The average rate on loans in my Lending Club portfolio is around 12.6% and I’ve made an average 9.6% annual return over the last four years.
That means about three percent of the loans I invested in, actually 13 loans of about 400, have failed to pay in that time and that 9.6% return is closer to 8.5% over the last year. But that 8.5% annual return with our example means we grow our portfolio to almost $300,000 over the 30 years and a profit of $226,000.
That 8.5% might not sound so hot against the 10% annual return in the dividend fund but understand that you want to diversify your investments. Having all your money in a stock fund, even a great dividend fund, sets you up for major losses during a market crash.
Peer lending returns will also be volatile around a market crash but they’re not going to fall as hard as stocks. You’ll still get that monthly cash payment from the loans being paid off and you’ll still get that compounding return working for you.
Compound interest investing is truly an amazing way to make your money work for you but it's not a miracle cure for your personal finances. Make sure you're investing in smart investments and have a plan to save money so you've got something to compound. Even on small amounts saved each month, you can grow your nest egg and achieve your goals.
Read the Entire Grow Your Money with Investing Series
- How to Make Small Investments to Get Rich!
- 6 Steps to Make Your Financial Assets Work Harder in 2021
- Road to Financial Freedom: Steps to Take to Be Financially Secure
- Fundrise Review: How It Boosts Your Real Estate Investing Opportunities
- Everything You Need to Know About Cryptocurrency Before Investing
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.