How can I take advantage of compound interest?

Factual Questions
1

In lots of finance books where they try to amaze you with the powers of compound interest, they use vague, academic examples to illustrate the calculations. Suppose you invest $10,000 at 7% interest and reinvest your gains, etc. etc. You’ll be rich in no time!

My question is, how can I do this in real life? Savings accounts and CDs have low, textbook-unworthy rates. The other thing I can think of is the stock market, supposedly with 10% returns. But prices go all over the place; how does compound interest apply there? The value of my stocks might just depreciate one day even after years of growth, and you will pretty much lose any compounding momentum you have going.

Please enlighten, as I would like to wield the universe’s most powerful force for profit.

2

Well, at the very least you can take advantage of the knowledge by understanding how it can work against you. An interest rate on a credit card, of say, 10% might look great until you read the fine print and see that it’s compounded hourly.

3

A 10% annual rate, compounded hourly, would still end up only being the equivalent of a simple 10.517%.

4

I meant 10% every hour.

5

This can and does happen, but reinvesting ensures you’ll still own more shares than you started out with, and for a long-term investment you should be able to ride out the rough patch until the stock rises again. In general it’s not a very wise idea to invest money you need, but if you can spare it for thirty years or so you can make a substantial gain.

6

Obviously, just about any savings account will let you enjoy compound interest, but as you realize rates of 0.05% will never yield (heh!) any appreciable growth of the balance in your lifetime.

However, here is an arrangement that would allow you to enjoy the benefit of compound interest at a reasonable rate of interest with relatively low, manageable risk. (I should note that it is possible that this type of negative amortization loan is not legal, but I would think that if reverse mortgages are allowable, this would be as well. It is not something I have actually looked into; it is just something I came up with in an attempt to satisfy your desire for compound interest at a reasonable rate with low risk.)

Yeah, just to be sure, I am not seriously recommending that you try to do this. This suggestion is just for your entertainment only:

Find a person who owns their house or other real estate free and clear, but is strapped for cash. The age range you should target will depend on how long you want to allow your money to compound. If you want it to compound for a long time (30 years or so), you should look for someone 45 to 55 y.o. or so. If you will be happy compounding interest for just five years or so, look for someone much older.

Offer him/her a mortgage on their property with the following terms. You will loan them $10,000 against their real estate, at an interest rate of 7%, or whatever you can get. They will never need to make a payment on the loan while they are alive. Instead, the interest will accrue to the balance of the loan. As the balance builds, the interest compounds.

When they pass away, the loan becomes due. The heirs may need to sell the property to pay off the loan. But when they do, voila! You will enjoy the miracle of compound interest that you crave! For example, if you are able to loan $10,000 at 7%, it will be worth over $76,000 if your borrowers live 30 years. At 5%, it will be a not too shabby $43,000.

Now, this is not something for a novice to do, and I am not seriously recommending that you try to do this.

Potential pitfalls off the top of my head: You would need to assess the property to be confident that its will retain enough value so that proceeds from its future sale at some unknown date will be able to cover your loan. (It is therefore essential that the initial loan be only a small fraction of the value of the property.) You would need to ensure that real estate taxes are paid every year, and that the loan gets paid off if the owner chooses to sell the property before they die. You would need to ensure that they maintain adequate insurance on their property.

There are risks as well, but not so many that are different from risks you would face in a more conventional compound interest savings vehicle.

There is the risk of rampant inflation destroying the value of your money. There is the risk of war or some other event that would not be covered by insurance destroying the property or the value of the property. There is the risk that the party you loaned the money to outlives you, but at least your heirs would eventually get paid. There is the risk that the property ends up being worth less than the amount due on the loan in the future. There is the risk that despite your best efforts, you somehow get defrauded and lose your money.

And of course you will face legal fees in setting up the loan, etc.

Plus there is the whole bad kharma thing of waiting for someone to die so that you can get your money.

And I am sure there are numerous other potential risks and pitfalls that I have failed to list here.

Your other alternative is to wait. Interest rates will go up again someday, and then you can set up a typical saving account paying more interest. Of course, inflation will likely be higher as well.

7

They do today, but just a couple years ago they were much higher. I made several thousand dollars just taking out balance transfers from credit cards at “introductory” 0% rates for 12 months and sticking the money into 5-6% CDs.

Look at the average interest rates over various historic periods of 10-20 years.

Past performance is no guarantee of the future, but I suspect over the next 10-20 years interest rates will climb at some point…

8

But that is not compounding, that’s just an insanely high interest rate.

9

That could be compounding an hourly interest rate hourly (if Koxinga adds the interest into the principal after each hour. It’s not clear, but I’ll give him the benefit of a doubt.) But the problem there, as you note, has nothing to do with the compounding–the problem is that you’re being charged an hourly interest rate which, compounded or simple, is going to cost a lot.

10

Sure, it was like that before the Fall of the American Empire… err, the Great Economic Collapse. I don’t think those rates will be bouncing back any time soon though. I use ING and they used to give around 5% interest on a regular savings account… now their top-yielding CDs yield a paltry 1.25%. It makes me cry.

11

Except that this also means that the prices of objects are not going up by at least 5% each year. Low interest comes about in times of low inflation. There are always two sides to every economic statement.

The answer to the OP’s title question can be stated in two words: you can’t.

Whatever rate you get when you save/invest your money is the best current rate, though. It doesn’t make any sense to not save exactly the same amount in times of low interest. It’s still the best you can do and without inflation eating into the power of your earnings it’s probably the same net results in the long term.

12

Right. The answer to the OP, who’d like to see interest compounding on a high rate is: (a) wait for macroeconomic change back to a higher-rate environment on quasi-cash investments (but realize that these environments often coincide with periods of high inflation – compounding at a rate below the rate of inflation isn’t so wealth-enhancing); or (b) take on more risk to goose the interest/return rate. Warren Buffett got a lot more than 1.25% on the notes he bought from GE and Goldman (I think it was either 10% or 15%). Retail investors can do something similar – it’s not difficult to buy distressed debt and that’s where the junk bond fortunes were made. I think you could without much effort find double digit yields on junk bonds. Of course, they are paying so high because there’s a risk of default. So you need to do your homework (i.e., find a company whose risk of default you think is overstated).

Another example: Greek government bonds have recently been pricing out at 7.1%. And you can figure out why. Greek Bond Yields Soar to 7.1% - WSJ

Oh, and to our discussion of 1.25% as the best going bank deposit rate – not quite that bad, at least for the longer-term investor (which is what you should be if you’re looking to compound, right?). Five year CDs can be found at about 2.75% right now. Still not great, but beats nothing.

So, take on a little risk, take the long view, and the compounding can start to work for you. And a final suggestion – in this low interest environment, I’ve got a lot of my cash parked in www.bankdirect.com, building frequent flyer miles through their partnership with American Airlines. I’ve figured out that after taxes, the interest I could earn in any quasi-cash account is worth a lot less than the value of the three or four trans-Pacific business class tickets I’m aiming to redeem over the next years from the miles spinning off that account. Got to be open to alternative investment vehicles.

13

The only compounding a rate that high will lead to is compound fractures when you miss a payment!

[rimshot]

14

So while it was possible for rates to fall in the very short time that ING has even been around, it would be impossible for them to rise in a similar time period? The most common economic fallacy is believing that the current situation is going to continue. The OP needs to make sure that his money is in an interest-bearing account, then the interest will compound. We happen as of this moment to be in a period of very low interest rates, but that will eventually change, and the compounding will have a greater cumulative impact. At that point, the board will be full of people complaining about the ridiculously high interest rates they are having to pay for mortgages and loans, and lamenting the good old days of low interest rates.

15

Buy long-term US Treasuries. Or, to facilitate the reinvesting part, a mutual fund or exchange-traded fund composed of long-term US Treasuries. These long-term bonds are offering 4-5% interest.

16

The only way to take advantage of compound interest is time. The compound part means you are getting interest on interest you have already earned. Find an investment vehicle you like and stay invested in it for a long time. If you invest in equities reinvest the dividends if you invest in debt reinvest the interest. The longer you keep doing this the more compound interest works in your favor.

17

**How can I take advantage of compound interest? ** Have you tried buying it some drinks? OK, sorry.

These days it’s hard to see interest compounding, at least when you look at basic bank accounts (my bank pays .25%!). I’d say it is most obvious when you look at mortgages. The terms are usually for 15 or 30 years and the rates are high enough to see the effect of compounding over that time.

As far as using compounding to help you, look no futher than an IRA or 401(k). They usually pay high enough rates that the growth is visable and, if you do the math, it is clear that the tax free aspect makes a huge difference in that growth.