Saving money is hard. It requires discipline and sacrifice.
However, once you have a certain amount saved up, that money will not only offer you security during financial hardships but it’ll also allow you to earn interest on the money you’ve accumulated.
Instead of exchanging your time (and labor) for money, you can now use your savings to earn more money without needing to invest any extra effort. This form of income is known as interest.
There are countless ways you can invest your savings to earn interest, depending on your financial goals and risk tolerance.
The Basics of Interest
Regardless of which financial instrument or savings account you use, the interest you earn on your savings is generated through the process of lending and borrowing. At the most basic level, these are the steps involved in generating interest:
- You deposit your money into a savings account.
- The financial institution lends this money out to individual or corporate borrowers in the form of loans.
- The borrower pays a certain rate of interest on the amount they borrowed.
- This rate of interest will depend on a number of factors, including current market conditions, the level of risk, and the duration of the loan.
- The financial institution will then pay a portion of the interest earned from borrowers to you (the depositor).
- If you invest in other forms of financial instruments like stocks or bonds, you’re lending money directly to the entity that issued the stock or bond you purchased.
- This form of investing may be riskier, but it also offers a higher rate of interest.
Why Earning Interest is Important
There are three major reasons why earning interest on your savings is so important:
- Wealth Creation: If you reinvest the interest you earn from your savings, this will allow you to build your wealth over time. Earning (and reinvesting) interest is a crucial step towards achieving your long-term financial goals and building generational wealth.
- Inflation: With every passing year, inflation causes your savings to lose some of their value (or purchasing power). Interest income is, therefore, essential for providing a hedge against inflation, ensuring that your savings retain their purchasing power over the course of your life.
- Passive Income: You don’t need to exchange your time and labor to earn interest, making it a ‘passive’ way to earn money. This can serve as a supplement to your regular income under normal circumstances. It can also provide a financial security net when you can no longer work due to old age or health problems (such as an injury or sickness).
Types of Interest
There are two main forms of interest that you can earn on your savings. These are:
Simple Interest
Simple interest is easier to calculate than compound interest since it’s only calculated on the principal. In other words, with simple interest, you cannot earn additional interest on the interest previously earned.
Typically, simple interest is more favorable for the borrower than the lender or investor since it means that the overall interest payment will be lower.
Some examples of financial instruments that generate simple interest are certificates of deposit (CDs) and Treasury Bills (T-Bills). These financial instruments usually come with lower risk to compensate for the relatively lower interest earnings.
Compound Interest
Compound interest is calculated on the initial principal as well as the interest accumulated from previous periods. As compounding allows you to earn ‘interest on interest,’ it is more beneficial for lenders and investors.
It can help multiply your savings at an accelerated rate if you can stay invested for a long period of time. The higher the number of years for which you invest your savings, the greater the effect of compound interest will be.
While interest can be compounded daily, monthly, yearly, or on any other schedule, most financial instruments offer annual compounding. This is the type of interest you can expect from most types of investments, including savings accounts, stocks, and bonds.
Best Way to Earn Interest on Your Money
There are various types of financial instruments that you can use to earn interest on your savings. Below, we’ve discussed some of the most important ones that can help you grow your wealth through interest income.
High-Yield Savings Accounts
A high-yield savings account functions the same way as a traditional savings account but offers a higher rate of interest. To earn interest, you simply have to open a high-yield savings account, deposit some funds into it, and maintain a minimum balance.
You earn compound interest based on the balance in your account. The interest earned becomes part of the principal and generates additional interest over time. You can easily withdraw part or all of your money from a high-yield savings account, making it a very flexible tool for earning interest.
Certificates of Deposit (CDs)
A certificate of deposit (CD) offers a higher interest rate (but less flexibility) than most savings accounts. To earn interest through a CD, you’ll have to deposit a fixed amount of money for a predetermined length of time – ranging from a few months to a few years – during which you can’t make any withdrawals. In return, you can earn interest on your money at a fixed rate until the CD reaches its maturity date, when you’ll be able to withdraw the entire amount.
Money Market Accounts
Money market accounts (MMAs) offer a higher interest rate than traditional savings accounts, but unlike certificates of deposit, their interest rates are variable and can fluctuate depending on market conditions. The interest is calculated based on the average daily balance, so maintaining a high account balance will help you earn higher interest. In addition, many MMAs offer debit card and check-writing privileges, ensuring that depositors have some flexibility with their savings.
Interest-Earning Checking Accounts
Interest-earning checking accounts are almost the same as regular checking accounts, except that they pay interest on the account balance. The interest rate is typically lower than a savings account, but the interest-earning checking account allows you to make unlimited withdrawals, pay your bills, write checks, etc. However, compared to a regular checking account, you’ll need to maintain a higher minimum account balance to avoid a monthly fee.
Bonds
Bonds can be issued by governments or corporations. They’re a type of fixed-income security that you must buy and hold for a specified amount of time until the date of maturity. When you buy a bond, you’re essentially extending a loan to the entity that has issued it. Bonds usually generate a fixed rate of interest which is paid on an annual basis (also known as coupon payments). At the time of maturity, the principal of the loan is repaid to the investor, along with the interest.
Mutual Funds
To earn interest from mutual funds, you should invest in one that holds dividend-paying stocks or bonds. The mutual fund earns interest from the financial securities that it holds, then reinvests the interest earned to compound over time. Mutual funds that focus on interest income (rather than growth or capital gains) might be the best option if earning higher interest on your money is your priority.
Investment Accounts
You can use an investment account to hold and manage financial instruments like bonds, stocks, ETFs, mutual funds, and CDs. These accounts can help you earn interest through interest-bearing assets like CDs, bonds, and dividend-paying stocks. Investment accounts like the Individual Retirement Account (IRA) and the 401(k) are commonly used to save for retirement, giving your savings time to grow through compound interest over the years.
Stocks
While stocks don’t generate interest in the traditional sense, they can help grow your savings in two major ways – through dividends or capital appreciation. Dividend-paying stocks can be used to generate a regular income stream, as they distribute a portion of the company’s earnings to stockholders in the form of dividends. Alternatively, you can grow your money through capital appreciation by buying stocks at a lower price and selling them at a higher price point.
Exchange-Traded Funds (ETFs)
An Exchange-Traded Fund or ETF is a pooled investment security that can be bought or sold on the stock exchange, just like individual company shares. ETFs can be structured to track a particular commodity, index, or industrial sector. The most popular ones track the S&P 500 or the NASDAQ-100 indices. Most ETFs earn interest in the same way mutual funds do – by reinvesting dividends, through capital appreciation, etc. – depending on the type of assets they contain.
Real Estate Investment Trusts (REITs)
A REIT is a financial instrument that pools investor funds to invest in income-generating real estate, such as shopping malls, apartment buildings, hotels, offices, and warehouses. The REIT may either finance these real estate properties or directly own and operate them.
REITs are traded publicly like stocks and bonds, making them a more liquid alternative to traditional real estate investments. As a result, they are a good way to diversify your portfolio and earn regular dividends, which can compound your money over time if reinvested.
Crowdfunding
Investment crowdfunding allows retail investors to invest directly in startups, real estate, expanding small businesses, etc., via a crowdfunding website like Wefunder or SeedInvest.
These websites bring entrepreneurs and investors together to make it easier to raise capital for a new project or business idea. Individual investors contribute small amounts of money and receive securities like debt or equity in return.
You can choose to invest in debt-based crowdfunding campaigns in order to maximize the amount of interest earned.
Peer-to-Peer Lending
P2P lending is a form of social lending that allows individuals to borrow and lend money without using a bank or other financial institution as a middleman. Typically, this is facilitated by an online P2P lending platform like Lending Club, StreetShares, or Prosper.
The interest rates and terms for these loans are set by the online platform, with borrowers paying higher or lower interest rates depending on their creditworthiness. For lenders, peer-to-peer lending websites involve higher risk but also offer higher interest incomes than traditional savings accounts or CDs.
How to Know Which Option Is Best for You
All the above-mentioned methods can help you earn interest in your savings, and they each have some advantages and drawbacks. For example, some offer higher interest rates, while others entice investors through better capital preservation and lower risk.
So, when choosing the investment option that’s right for you, here are some of the important factors you need to consider:
Available Funds
The amount of money you have and can realistically invest is one of the important factors you should take into account when choosing the best way to earn interest. If you have a relatively small amount to invest, then a safe and flexible option like a high-yield savings account or money market account might be more favorable than riskier options like stocks and bonds since these involve a greater risk of loss.
Typically, they also require a large principal and long investment horizon to generate significant returns. This may not be realistic for someone who only has a small amount of extra savings, which they might need to use for a sudden emergency.
Access to Your Money
Another factor to consider is how much flexibility you need with your investment. If you have a well-funded emergency fund and are sure you won’t need to touch your investments for the next few years, then CDs, stocks, and bonds might be the best way to earn interest for you. These financial instruments offer high returns, but only if you can stay invested over a long period of time.
On the other hand, if you need to have constant access to your money, then a more flexible investment option like a high-yield savings account, interest-earning checking account, or an ETF might be the most suitable.
Your Needs and Goals
The next thing to consider might be your own financial needs and goals. If you’re a young professional trying to save and invest for retirement, you may consider using an investment account like IRA or 401(k) to build a well-balanced portfolio with stocks and bonds. You can start out with more growth stocks in your portfolio and shift slowly towards bonds and ETFs as you grow older.
On the other hand, if you’re trying to save money for a short-term goal like a downpayment on a house, a wedding, or buying a car, then you should invest in a vehicle with less volatility, like a CD or a high-yield savings account. Investment crowdfunding or peer-to-peer lending might be the right option for you if your goal is to maximize returns and you’re willing to take on extra risk to do so.
Duration
Different investment vehicles require different time horizons to generate the best possible returns. If you can stay invested for a decade or more, then mutual funds, stocks, bonds, REITs, and CDs might be the best investment options for you. However, while you can withdraw your money from mutual funds, stocks, or bonds at any time, you’ll need a long-term investment outlook to earn the best returns.
On the other hand, if you need daily liquidity, then you should choose high-yield savings accounts, interest-earning checking accounts, ETFs, and money market accounts. Peer-to-peer lending and investment crowdfunding websites are for those investors who have a medium-term investment horizon – meaning that they don’t need daily liquidity but might want to withdraw their money after a few years.
Concluding Note
When making your decision, be sure to carefully consider your own risk tolerance, financial goals, and expectations so that you can build a diversified portfolio of investments structured specifically to meet your needs. This will help you make the most of your savings in the long term while also earning substantial interest on your money.
