- What is compound interest?
- How does compound interest work?
- Simple vs. compound interest
- How can compound interest work against you?
- How do you calculate compound interest?
- Compounding interest: Pros and cons
- How to benefit from compound growth
- How to keep compounding from costing you money
- FAQ: What is compound interest?
As anyone who has asked their parents to buy them something knows, money doesn’t magically grow on trees. Under the right conditions, however, your money can grow (seemingly magically) inside a savings or investment account. That’s the power of compound interest: It can either supercharge your savings or, if you’re not careful, balloon your debt. Learning how to wield this double-edged sword is key to building a healthy portfolio and meeting your financial goals.
What is compound interest?
Compound interest — or compound growth — refers to interest earned on interest or gains derived from gains. When you deposit money (known as principal) into a savings or investment account, it generates a return. In the case of dividends and interest income, compounding interest results when the income is reinvested back into the same investment. In the case of capital gains, a buy-and-hold strategy can grow the investment’s value over time. The longer this process plays out, the greater the benefit to your savings may be.
An easier way to picture the process is to imagine your initial savings as a tree you plant in your backyard. It may not drop dollar bills directly on your head, but over time, it is likely to produce a type of interest in the form of seeds. If you plant those seeds in the same yard, you’ll soon have more trees that also produce seeds. As you harvest the seeds from more trees — or re-invest the money you’ve already earned — your initial investment of just one tree can grow into a forest.
The key to maximizing the benefits of compound growth is to start saving early and make regular contributions as often as possible. The more opportunities your initial investment has to benefit from the compounding process, the healthier your forest — and finances — will be.
How does compound interest work?
The impact compounding can have on your portfolio can’t be overstated. Here are a few examples of how even a small investment can take advantage of this strategy and grow over time:
How much would you have made by retirement if you invested $5,000 at age 40?
Imagine you put $5,000 in a registered investment account at age 40 and left it there until you retired at 65. If you never added another dollar to this account and simply re-invested any income it generated, by the time you retired 25 years later, your money would have grown to $21,459 (assuming a 6% rate of return). That nearly $16,500 gain on a $5,000 investment wouldn’t be possible without the power of compounding interest. Of course, it will depend on the type of investment account you put your money into. Brokerage investment accounts, for example, that hold regular stocks cannot guarantee consistent returns because no investment is risk-free. Your investment may fluctuate. Similarly, a savings account interest rate is also likely to fluctuate over time.
How much would you have made by retirement if you invested $5,000 at age 30 or 20?
Making $16,500 on a $5,000 over 25 years may sound great, but it pales in comparison to the money you could have made if you started investing a little sooner. If you began at age 30, for example, by the time you retired 35 years later, you would be looking at $38,430. If you started at age 20, your initial $5,000 would have grown to a whopping $68,823 after 45 years (still assuming that 6% rate of return.)
What if you invested $5,000 and then added $1,000 every year?
Now that you’re starting to see the forest and not just the trees, imagine how much money you would have upon retirement if, in addition to your initial $5,000 contribution, you added another $1,000 a year to your investment account until you retired. If you started doing this at age 40, thanks to compound annual growth, you could find yourself with $75,063 by the time you turned 65. If you started at 30, your investments could have grown to $148,330. But, if you started at the age of 20, your nest egg could be worth a mouth-watering $279,541.
Simple vs. compound interest
Compound interest is when the interest you earn on your principal begins to earn interest of its own, helping to accelerate your savings. It allows your money to grow faster than simple interest, which is calculated solely on the principal you invest and not on top of any interest generated. Here’s an example:
Initial investment: $5,000
Interest rate: 5%
Simple Interest | Compound Interest | ||||
---|---|---|---|---|---|
Interest Earned | Total | Interest Earned | Total | Difference | |
Year 1 | $250 | $5,250 | $250 | $5,250 | – |
Year 3 | $750 | $5,750 | $788 | $5,788 | $38 |
Year 5 | $1,250 | $6,125 | $1,381 | $6,381 | $131 |
Year 10 | $2,500 | $7,500 | $3,144 | $8,144 | $644 |
Year 25 | $6,250 | $11,250 | $11,932 | $16,932 | $5,682 |
How can compound interest work against you?
If you let it, the same compounding process that can supercharge your savings can do the same to your debt. That’s because most credit cards use compound interest when calculating how much you owe every month. Credit cards have an annual percentage rate (APR) that is often in the range of 19% (although some can reach 29.99% or higher). The greater the APR, the more interest you’ll need to pay on your unpaid balance.
If you miss a monthly payment or only pay the bare minimum, you’re allowing your debt to “benefit” from the power of compound interest in the same way your savings do.
While everyone should have an overall financial plan, when it comes to repaying debt, financial commentators often recommend focusing on credit cards with the highest rate of interest first — they’re usually the ones costing you the most money. The sooner you pay those balances off, the better your financial health may be.
How do you calculate compound interest?
The easiest way to visualize how life-changing compound interest can be is to use a compound interest calculator. To gain a better understanding of the outsized impact the decisions you make can impact your future finances, you simply need to enter a few variables. These include:
- The amount you contribute initially
- The amount of time you plan to invest
- How often (and how much) you plan to contribute over time
- The annual rate of return you expect
With the press of a button, the calculator will reveal exactly how helpful compound interest can be to your savings over time. Small investments can yield big returns when you let compound interest do the heavy lifting for you.
Compounding interest: Pros and cons
Compound interest is one of the pillars of our financial system. If you make and spend money, you are likely to feel the impact of it in different ways.
Pros
- It can help maximize your returns: Your investments grow faster because you’re earning interest on the interest you have already earned
- Size doesn’t matter: You can start small and still experience big benefits over time
Cons
- Time is of the essence: Compounding often doesn’t make as big a difference over short periods when it comes to growing wealth. You need to start investing early at a decent interest rate for it to really pay off. The ideal investing environment is high rates of return over long periods of time.
- It cuts both ways: Your debt can grow as quickly as your savings if you’re not careful
How to benefit from compound growth
Utilize registered accounts
Some of your income may be lost to taxes if earned in a non-registered account. By utilizing your TFSA or RRSP, your gains are sheltered from tax as they grow which can accelerate the process.
Start investing early
The more time interest has to compound, the faster it grows. Starting early in life (perhaps by opening a TD Direct Investing account) can make a big difference towards your financial goals. Even investing small amounts of money can pay off over time.
Stay invested
To maximize the benefits of compound interest, it helps to be patient. You may want to consider limiting withdrawals and re-investing any interest or dividends you earn. Of course, with any investment, there are risks to consider. Losses can and do happen. Generally speaking, however, the longer you allow your savings to benefit from the compounding process, the greater the payoff may be.
How to keep compounding from costing you money
Check your annual percentage yield
Be sure to pay attention to how much interest your credit card charges you annually. The larger this percentage, the more interest you’ll be charged on any amount left unpaid.
Pay off debt with compound interest
If the money you owe is calculated using compound interest — as most major credit cards do — missing a monthly payment (or even just paying the bare minimum) can turn a small debt into one that is extremely hard to get rid of. To minimize the damage, consider repaying debt loads with the highest rates of interest first, as these are the ones doing the most damage to your bottom line.
FAQ: What is compound interest?
What is compound growth for dummies?
When you invest money, it earns income in the form of interest, dividends or capital gains. When you re-invest that income, you can start to earn more money off your gain. The longer you let this process play out, the more you can make.
What are the three types of compound interest?
Interest can be compounded at a range of intervals, including daily, monthly and annually. The more frequently it is compounded, the quicker your money will grow.
What is the negative side of compounding?
The power of compound growth is great for investors, but it can also drive up your borrowing costs. If you don’t make regular payments on your debts or pay only the minimum, you’re letting the process work against you.
What is the number one rule of compounding?
The first rule of compounding, according to noted U.S. investor Charlie Munger, is to never interrupt the process unnecessarily. Compound interest, by its nature, is backloaded. That means the longer you leave it in place, the greater the returns you are likely to receive. If you pull this money out early, you risk missing out on some big unrealized gains.
What is the Rule of 72?
The rule of 72 is a simple formula that may help investors determine how long it will take for a particular rate of interest to double the value of their investment. Simply divide the number 72 by the rate you hope to get to determine the length of time you need to stay invested. For example, if you are receiving a 6% rate of return, it will take around 12 years to double your investment (72 ÷ 6 = 12).