Where Can You Earn a Good Compound Rate of Return When Interest Rates Drop?

by Gary Foreman

You might be happy with the current interest rates some banks are offering on savings accounts and CDs, but rates won’t stay high forever. So where should you consider moving your money to once rates drop back down that will still allow you to earn a good compound rate of return?

Dear Dollar Stretcher,
I have been taking advantage of today’s high interest rates by moving my savings account balance into a high-yield savings account and 12-month CD. But we all know that interest rates will come back down at some point and I want to be prepared to move my money again. But I’m not sure where to put it so I can get comparable returns to what I am earning right now — or even better returns.

Where should I consider putting my money once interest rates on savings accounts and CDs drop back to where they were a few years ago?
Jennifer

Jennifer understands the value of compound interest and she’s wise to take advantage of the high interest rates while she can. Before we get into where she should move her money next, let’s review a little about compound interest for those who aren’t that familiar with it.

What Is Compound Interest?

Compound interest is really pretty simple. If you loan money, you expect to earn a specific amount of interest over a specified time (for instance, 4% per year). Suppose that you leave the loan open for a second year. If your loan were earning “simple” interest, it would earn the same rate and amount as the year before.

But, in a compound interest loan, instead of taking the interest you earn, last year’s interest is left with the original principal. The new interest owed is calculated on that sum. So you’re also earning interest on last year’s interest. And, that’s “compound” interest.

The concept is best discovered at an early age because the results are most impressive after long periods of time. A dollar saved in your 20s is much more valuable than one saved in your 50s.

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An Example of How Compound Interest Works

Let’s look at an example. We’ll suppose that Jennifer has $1,000 in savings and that she earns 4% on it annually. She’s probably earning more than that on her high-yield savings right now. Further, let’s say that she leaves it in the bank for 50 years at the same 4% rate and that the account isn’t compounded. At the end of the 50 years, she’ll have $3,000 (the original $1,000 plus $2,000 in interest earned).

That example isn’t completely realistic. Very few people would leave money in a simple interest account for 50 years, but the example is instructive because we’re going to compare it to the results earned by compound interest.

So what happens to our example if the interest is earned and compounded annually? Jennifer’s $1,000 becomes $7,106 in 50 years. You wouldn’t think that earning 4% interest on a measly $40 could make such a big difference. But it does. The interest earned the last year alone is $273. Thank you compound interest!

What about timing? At the end of 30 years, the $1,000 will only grow to $3,243. That means that about 63% of the increase takes place in the last 40% of the time. So, the sooner that Jennifer gets going, the better.

Where Can You Earn a Good Compound Rate of Return When Bank Interest Rates Are Low?

Now to the meat of Jennifer’s question. Where can you earn a good compound rate of return when interest rates drop again? She’s right that rates won’t stay high forever. But, in fairness to savings accounts, they do guarantee that you can’t lose any money.

Jennifer might want to consider a mutual fund account next. With mutual funds, if you automatically reinvest any dividends, interest or capital gains, then it’s the same as getting compound interest. Technically, it may not be called interest, but the money spends just fine!

We don’t have the time to discuss long-term investing here, but a basket of common stocks has always performed well. Even if you happened to buy right before a market crash (like 1929). Even if Jennifer only earns 6% on her investment, which she should over the long-term, that’s more than she’s earning now in her high-yield accounts.

If we put Jennifer’s $1,000 to work compounding at 6% annually, it will grow to $19,935 after 50 years. Not bad for a one-time investment of $1,000.

We won’t try to pick a mutual fund for Jennifer. Unfortunately, a single email from her can’t provide enough personal information to allow for good advice in that area, but that shouldn’t prevent her from finding one herself.

She can find an introduction to funds from the Securities and Exchange Commission. Comparisons are available at Kiplinger.com and other websites. Look for well-established no-load funds with a long past record of success.

Compound Interest Can Work Against You

Here are two final thoughts. It’s also important to realize that compound interest can work against you. Carrying a balance on your credit card is a good example. So, the first way to take advantage of compound interest is to pay off any credit card balances you’re carrying.

Finally, we should note that compound interest is nothing new. In fact, Ben Franklin promoted it centuries ago. In his will, he left $5,000 each to the cities of Boston and Philadelphia. Each city was to have a fund that would last for 200 years. The money was to be loaned to needy young people at 5% interest. After 100 years, each city could withdraw $500,000 from the fund, leaving the rest to work for the second 100 years. The cities managed to deviate a bit from Franklin’s plan, but they did clearly demonstrate the benefits of compound interest.

Reviewed October 2023

About the Author

Gary Foreman is the former owner and editor of The Dollar Stretcher. He's the author of How to Conquer Debt No Matter How Much You Have and has been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.

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