Disclaimer: The statements made in this post are the opinion of the author. They should not be viewed as financial advice. Please consult with a financial specialist before making any financial decisions.
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There is a wonderful kids book called “If You Made a Million” by David Schwartz (illustrated by Steven Kellogg) that goes into the concepts of money and interest building up over time until you have one million dollars.
The lessons it teaches are good, but the book, published in 1994, is a bit outdated on their claims of interest.
For example, they say that if you put 1 dollar in the bank that at the end of the year you’ll have $1.05.
A 5% interest rate at a bank sounds like a pipe dream (though there are some ways to get it), but generally speaking our interest rates are much lower today.
So how much does 1 million pay in interest?
That is a surprisingly complicated question, but we’ll get there.
What is Interest?
To make the definition as simple as possible, interest is just money put on top of money that is calculated as a percent.
So 10% interest of $100 is $10. That much is straight forward.
The next thing to understand is which direction the interest is going. In other words, is it going into your pocket or coming out of your pocket?
Interest paid to your savings account, for example, is money going into your pocket.
Interest paid on a car loan, on the other hand, is money coming out of your pocket.
These two types of interest are called financing interest and investing interest respectively.
When you ask about the interest rate on $1,000,000 you are asking about investing interest.
How Is Interest Calculated?
Now that we get what interest is and what kind of interest we are wondering about, the question remains, how is this money that you get back on what you put in calculated?
There are two different ways that your interest could be calculated. Either simple interest or compound interest.
Simple interest is basically the example I gave above. I put $100 in and I got $10 because my interest rate was set at 10%.
This is the easiest type of interest to understand because the math is really simple. 100 times 10% (.1) equals 10.
The problem is there are actually very few examples of real simple interest in finance. This is because money is dynamic. It is always changing and flowing around so simple interest is almost impossible to do.
Often simple interest is combined with the other form of interest and this is in the form of interest paid up front. If you get a loan and you are required to pay 5% in interest up front, that is an example of simple interest.
Usually on money that you are getting paid interest on you won’t get an upfront payment, but it is possible.
Since simple interest isn’t common for investors, we won’t factor it into our interest rate on one million dollars.
Compound interest is the more common form of interest and it is simply when interest adds interest on top of interest. That sounds confusing, but let’s say you invest that $100 at 10% and you end of with $10.
If you keep that $10 invested then the next payment will be for $11 because your original $100 plus your $10 in interest equals $110. Times that by 10% and you have $11.
Because your savings account will pay you interest and then pay you more interest on top of that interest they’ve already paid you, a savings account is an example of compound interest.
In the other direction your mortgage is an example of compound interest as well since your interest depends on how much principal you owe as well as interest accumulated on the loan.
The longer you let your original money sit the more it will grow and build upon itself.
So if you have one million dollars you are probably thinking “I want compound interest”! Which is absolutely right.
But hold on, what kind of compound interest? Compound interest sounds great, but there are different levels of compound interest, and you want the best one possible.
The first kind of compound interest is annual interest. In this case your advertised interest rate is exactly what you get.
You put in $100 at 10% at the end of the year you will have $110 because the 10% interest is applied only once.
That is $10 you didn’t have to work for, but you’re probably wondering how you can do even better.
The next step up is monthly compounding interest. Now a common misconception is that you will get you full interest rate monthly instead of yearly.
Or going the opposite direction that you’ll be charge the full 18% (on average) credit card interest rate each month you keep a balance on your card.
What actually happens is that your rate is prorated or spread out over each month and applied depending on how much money is in your account.
So to make it easy, if you have a 12% interest rate, the first month you have 1% interest, then the second month you have the next 1% and so on.
You might be thinking, so what?
Well, to answer that question, if you have $100 invested at 12%, the first month you’ll be paid $1. The next month you’ll be paid 1% of the $101 you now have, so you’ll make a $1.01 that month and so on.
That might not sound exciting but over the course of years, and with larger sums invested, it really starts to add up.
Daily compounding interest then is the best that you can get. Instead of prorating the the interest over 12 months it is prorated over 365 days and it keeps building on itself over time.
To demonstrate the power of daily compounding, let’s take that one million dollars we want to invest and put it in a 10% annually compounding account. In one year you will have $1,100,000. Hurray!
But if you invest it in a 10% daily compounding account you will end up with $1,105,155.78. That is over a $5,000 difference!
Over ten years, the annual compounding account will have $2,593,742.46 but the daily compounding account will have $2,717,909.55!
$200,000 is a BIG difference.
So that’s why you want a daily compounding interest rate.
To play with the numbers yourself, use this compound interest calculator.
What Interest Rate Can I Get On 1 Million Dollars
Now, 10% is a pretty wild interest rate. Especially from a bank. So let’s look at some real numbers. This will give us an idea of what you can actually make with a real interest rate on 1 million dollars.
The amount of interest you can get has to do with a couple things. First, how much risk you are taking on. Second, the time frame for withdrawing funds.
An Easy to Get Low Interest Rate
Savings accounts are the easiest of any investment. The least risky. And therefore the least rewarding.
Following the guidelines given above, a savings account is extremely safe since it is backed by the FDIC and you can withdraw money at any time so the time frame is extremely short.
Both of these together give savings accounts extremely low interest rates.
I’m talking 0.01% on some savings accounts with high end savings accounts currently around 0.5% if you’re lucky.
If you’ve got 0.01% on $1,000,000 then you would end up with a whopping $100 in interest at the end of the year. Even if you could get 2% you will only have $20,000. That isn’t much to live on and it doesn’t even keep up with inflation which is about 2-3% per year.
So you probably want to invest in something with a higher interest rate.
An Easy to Keep Medium Interest Rate
The next level up are low risk items that have a longer investment time frame. In other words, you are required to keep that money in that account for a certain amount of time.
Examples of this are investing in Certificates of Deposit (CDs) and Bonds.
In general a CD or a bond will have a specific amount of time that your investment must stay in place in order to get the promised return.
Trying to withdraw early incurs penalties, so you don’t want to use a CD or a bond as a savings account. But that early withdrawal penalty allows them to pay out slightly higher interest rates.
Honestly, CDs are not much better than savings accounts. You can get a slightly higher rate, but I mean only slightly. So let’s ignore those for now because there are plenty of high yield savings accounts that pay out as much as CDs are right now.
Bonds are currently performing poorly as a result of the low interest rates following the government response to the pandemic (2020).
Historically, however, they average around 3.8% which is just enough to beat inflation. Barely.
If you got that 3.8% then you could live on $38,000 a year (slightly higher because it is compounding interest) which isn’t terrible. But you’d have to wait five years to get the payout.
A Harder To Find High Interest Rate
There are ways to get regular old interest, however, on 1 million dollars that pays better rates. However, it is a higher risk and longer payback time frame. Which is why the reward is higher.
This is through peer-to-peer lending.
Peer-to-peer lending is when you become the bank and lend your money to friends and family, or lending through a site like lending club to people across the country.
You can get some ridiculously high rates (like up to 36%), but those are on the riskiest investments. So you’re just as likely to lose your million.
A less risky, but still healthy interest rate is more like 6%.
That is more like $60,000 a year, which is money many people could live on without having to work again.
The key is finding the right people to lend to and then understanding that making a mistake could cost you money. That’s where the risk comes in.
But there has got to be a better way.
Investing Pays Better Than Saving
As you may have noticed, going from the lowest paying to the highest paying interest rates is really a move from saving towards investing.
Still, all three of the levels of interest rates on $1,000,000 are about putting money in to get a certain interest rate back.
While there is a place for that, if you really want to make some money with your one million dollars you’re going to need to invest for equity, dividends, and appreciation over the long term.
Related: 3 Types of Income; an explanation of how investors make money
There is nothing that compares to the return on investment from equity and appreciation because the upside is limitless.
For example, if you invested $1,000,000 at a 6% interest rate in 2004 and left it there for 15 years then you’d have $2,396,558.19 in 2019. Not a bad chunk of change.
But if you’d invested all of that into Google (to be extreme) at $85 a share when they went public you would own 11,764 shares of Google. 15 years later (August 2019 worth about $1,196 per share) it would have been worth $14,069,744!
That is 7 times as much money as getting 6% interest!
Related: What is a good Return on Investment?
Now, I’m not telling you to go and invest one million dollars into one stock that you think it a winner. That is a terrible idea. I’m just trying to show you the almost limitless upside potential of equity investing.
Also keep in mind that some businesses pay out dividends, which can increase your cashflow while you hold on to your stocks to build equity.
Where To Deposit 1 Million Dollars
Lucky for all of us there is an option that has the best of everything. Relatively low risk. Money you can access relatively easily (though the longer you keep it invested the better). And historically high returns.
It is called an Index Fund.
An index fund allows you to invest in every publicly traded company or other large bundles of companies without having to actively manage your accounts.
All you do is throw the money in and let it do its magic.
Over roughly that same 15 year time period we’ve been discussing one of the most famous index funds, VTSAX (Vanguard Total Stock Market Index Fund) has had an average yearly return of just over 10%!
That means that on average (remember some years are down years) you would make $100,000 on your initial $1,000,000. Not to mention the power of compounding returns by keeping your money in the market.
So, if you have one million dollars that you are wondering what to do with, talk to your financial advisor about putting it in an index fund.
If they aren’t a fee only financial advisor they may try to steer you elsewhere because they’ll make more money with an actively managed fund. But trust me, index funds are the way to go.
Where would you put one million dollars if you had it? What is the best alternative investment for one million dollars? Tell me about it in the comments below.
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A list of definitions used on this blog can be found here.
Financing Interest: The amount of money that you pay each month on top of the principal, the cost of borrowing money. So if you borrowed $100,000 you can pay an extra $40,000-$60,000 on average for a mortgage. This is the first I in the common banking acronym PITI (principal, interest, taxes and insurance).
Investing Interest: Money returned on top of the original amount of money invested. For a very simplified example, if I invest $1,000 at a %10 interest rate than I can expect to receive $1,100 back.
Simple interest: A one time payment of the interest percentage on the original amount that is lent. A 10% simple interest on $1,000 would be $100.
Principal: The amount of money that you pay each month towards the original amount of money you borrowed. So if you borrowed $100,000 you will pay $100,000 in in principal over the course of the whole loan. This is the P in the common banking acronym PITI (principal, interest, taxes and insurance).
Certificates of Deposit (CDs): A savings account that keeps a certain amount of money for a certain amount of time in exchange for a higher interest rate than the bank usually provides. After the agreed amount of time the principal is paid back along with the accumulated interest. Banks often have penalties for withdrawing the money early.
Bonds: To raise funds for a project an entity (usually a government) will sell bonds or certificates saying that if you pay X amount now you will get X back with interest later. This gives them the money they need now and gives the investor interest on their original investment later.
Equity: The amount of ownership that you have in an asset such as stocks. As the value of the stocks grown the amount of money they are worth increases even though the percentage of equity you own stays the same.
Dividends: Money that is paid back to the people that own portions of stocks (called shares) of certain companies when those companies make a profit. If you own some shares of a company that pays dividends, then you’ll get paid according to how many shares you own.
Appreciation: When the value of an asset increases overtime. For example, your home goes from being worth $100,000 to $105,000. That is 5% appreciation. This is not the same as cash flow or dividends which are other ways that assets can pay you directly.
Return on Investment: How much money you get back, usually measured yearly, on the money you invest in something. For example, if you invest $1,000 and receive $100 back from that in the course of a year then you’ve had a 10% return on investment.
Cash Flow: Money coming into your pocket from investing (either through stocks, real estate, or other assets). This is NOT the same as income because it doesn’t necessarily require you to work for it.
Index Fund: A way to invest in stocks that puts a little bit of your money into every company listed in that index or list of companies. For example, the index could invest in all companies in the S&P 500 or all publicly traded companies, etc.