Investment Basics
38 The Effect of Compound Interest
Anne Lee
As an individual builds up savings, we want to have a strategy to allow the accumulated wealth to grow. If leave the savings in a chequing account, we remember from Chapter 7 – Saving for the Future that the cash won’t be as valuable as time passes due to the rising cost of inflation. Therefore, investing excess funds can assist in not only combatting inflation but also gather and surmount a fortune.
When funds are in a common savings account, the base amount of interest earned on the principal amounts at a set interest rate is called simple interest. As one leaves the money growing in an account, both the principal amount as well as any earned interest will apply the set interest rate and grow in an exponential manner. Compound interest is calculated based on the principal amount and the accumulated interest of previous periods. Earning interest on already earned interest is called the compounding effect.
Compounding can create a snowball effect, in that original investments plus the income earned already from those investments would allow an increased principal to be applied to grow faster.
Example: Compounding Interest
Louis has a savings account that pays 5.0% interest per annum. Louis has put in $15,000 into the account in case of an emergency. In the first year, Louis will earn $750 ($15,000 principal x 5.0% interest). If Louis pulls out the earned $750 from the account, the following year’s earnings will remain the same. If Louis keeps the interest in the account and allows it to grow another year, then the second year interest would be $787.50. This is calculated with the $15,000 principal + $750 interest = $15,750, then multiplying by the same constant 5.0% interest rate in the following year. Now Louis is earning a higher interest amount due to the compounding effect of the interest earning on interest. In the third year, Louis would earn interest income of $826.87 ($15,000 principal + $750 interest year 1 + $787.50 interest year 2) x 5.0%, with total cash funds of $17,364.37.
Year Interest ($) Cash Funds
- Year 0 $0 $15,000.00
- Year 1 $750.00 $15,750.00
- Year 2 $787.50 $16,537.50
- Year 3 $826.87 $17,364.37
Depending on the time horizon of the assets, the amount of interest on interest will be growing significantly higher each year.
To get the most out of compounding, some strategies to utilize include:
- Invest early – having money invested longer allows more time for it to grow. Time is a significant advantage when it comes to compounding returns, as the growth escalates exponentially
- Contribute regularly – The important factor is to start being consistent with contributions into investments. Small contributions each month will accumulate and grow, and your savings contributions can increase as your level of income increases (eg. become a certified Journeyperson)
- Leave the funds inside the account – It is difficult to predict when the market may be at its highs or lows. Not taking the money out of the account allows the best chance to have the savings grow and earn compounding returns.
Whether saving through a tax-advantaged account such as RRSP, a TFSA, or a taxable account, saving early and saving often can provide a tremendous head start on the financial independence train due to the effect of compounding interest.
