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Compound interest can accelerate your efforts to build wealth by generating returns not only on your investments but also on the gains you earn over time. The best way to earn compound interest on your investments is by reinvesting the earnings you receive from your portfolio, particularly income in the form of dividends.
Here are some of the best investments for taking advantage of compounding by reinvesting your earnings, as well as some honorable mentions for short-term savings you don't want to risk in the market.
1. Dividend Stocks
Buying a stock gives you a share of ownership in a publicly traded company. As the price of a stock fluctuates, you may benefit from an appreciation in its value. Additionally, many companies pay dividends to their shareholders—often on a quarterly basis—which you can reinvest to earn more compound interest.
Many brokers offer a dividend reinvestment program (DRIP) that automatically reinvests dividends you earn by buying more fractional shares of the company's stock. If your broker doesn't offer DRIP, you can reinvest dividends you receive on your own.
2. Series I Savings Bonds
Series I savings bonds, called I bonds for short, are government bonds issued by the U.S. Department of the Treasury. These bonds earn interest each month based on a fixed interest rate and a rate that adjusts every six months with inflation.
I bonds also compound the interest you earn semi-annually, allowing you to grow your earnings more quickly compared to other types of bonds.
I bonds have maturities of 30 years, but you can cash in your I bond as early as 12 months after you originally bought it. Just keep in mind that you'll lose three months' worth of interest if you cash in sooner than five years.
3. Exchange-Traded Funds
Exchange-traded funds, ETFs for short, own a "basket" of stocks, bonds and other investment securities. In many cases, ETFs track a specific index, such as the S&P 500. This fund approach makes it possible for investors to diversify their portfolio without needing to buy a wide variety of individual securities.
When you buy shares in a dividend ETF, you can reinvest the dividends you earn back into the fund, compounding your returns. Some brokers offer DRIP for ETFs, making the process easy. Some examples include the Vanguard Dividend Appreciation ETF, the ProShares S&P 500 Aristocrats and the JPMorgan Equity Premium Income ETF.
ETFs tend to charge low fees. Also, because ETFs trade on stock exchanges like the New York Stock Exchange, you can easily buy and sell them at will.
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4. Mutual Funds
Similar to ETFs, mutual funds own dozens or even hundreds of assets. Mutual funds may track a specific index or focus on a specific asset or stock sector. You can also notify your broker or mutual fund company to automatically reinvest the cash you receive from dividends into the fund or do it on your own.
Unlike ETFs, mutual funds aren't traded on major exchanges. They may also have minimum investment requirements to buy shares, and fees tend to be higher compared to ETFs because they are often actively managed.
The investment risks associated with mutual funds are similar to those of ETFs, so it's a good idea to spread out your investments across multiple asset classes.
5. Real Estate Investment Trusts
Real estate investment trusts (REITs) are companies that invest in income-producing residential and commercial properties. REITs are required to pay out at least 90% of their income to shareholders in the form of dividends, which you can reinvest to compound your returns.
Because some REITs trade on public exchanges, you may also benefit from the appreciation of the share price for the company.
Because REITs invest in a variety of properties, they can help mitigate some of the risks of individual real estate investments. That said, they're still exposed to the risks inherent in the real estate market, so you'll still want to invest in other assets.
6. Compounding Interest for Short-Term Savings
If you want to earn compound interest, but you're not interested in dealing with the risks associated with securities, you may consider a deposit account that offers interest on your balance. Options include:
- High-yield savings accounts: High-yield savings accounts function the same as traditional savings accounts, but they tend to offer interest rates much higher than the national average. You can easily access your funds with a bank transfer or possibly even an ATM card.
- Money market accounts: A money market account acts as a hybrid between a checking and savings account. You may be able to earn a higher interest rate than with a high-yield savings account, and you may also be able to access your funds with a debit card, paper checks, bank transfers or an ATM card. That said, some money market accounts have monthly maintenance fees if you don't meet balance requirements.
- Certificates of deposit: Certificates of deposit (CDs) often offer higher interest rates than money market and high-yield savings accounts. To earn it, though, you'll need to lock in your funds for a set period of time. During that time, your interest rate remains fixed, but if you withdraw early, you may be subject to a penalty.
Consider Consulting With a Financial Advisor to Define Your Investment Strategy
If you want to make the most of compound interest investments, you may consider working with a financial advisor to determine how to structure your portfolio. An advisor can provide personalized guidance based on your current situation and your short-, mid- and long-term financial goals.
If you want, you can also hire an advisor to manage your money on your behalf, for which you may pay an annual fee, commissions or an hourly fee. Otherwise, you can simply consult with your advisor for an hourly fee and invest on your own.