Getting ahead in your finances can often feel like a never-ending battle. You work your butt off, but it doesn’t seem like you’re making a dent. Luckily, you can actually put your money to work, with a secret weapon known as “compound interest”. It truly works wonders, which is probably why Einstein himself deemed it the 8th Wonder of the World.
Here’s a deep dive into the magic of compound interest – what it is, how it works, and why you shouldn’t go another day without taking advantage of.
Laying the foundation with simple interest
In order to best understand the wonder of compound interest, we’ll use an illustration to map things out. Imagine that you have $1,000 that you’ve saved up over the Summer. You can do three things with that money.
- Spend it
- Put your $1,000 in a savings account
- Put your $1,000 in an investing account
Now let’s look at the outcomes of each scenario after 1 year…
- If you spent your $1,000, you would have none of it left.
- If you put it in a savings account, earning 1% interest, you would have $1,010. Meaning you’ll have earned only $10 in interest.
- If you invested it, say in your TFSA, and your investment made a 6% return that year, you would have $1,060 by letting your initial $1,000 (aka. the “principal”) sit in the account .
The above scenarios outline what’s known as “simple interest”. To get more bang for your buck though, compound interest is the way to go.
Here’s why compound interest is a big deal
Compound interest adds interest on the interest. So, the longer you let your money sit, the more you can make on the initial, principal amount. That means that according to our example, in Year 2, you’d earn an additional 6% on the $1060.00 you made in Year 2. To see exactly how this money would continue growing year over year, take a look at this chart:
|Year||Compound interest rate||x||Principal balance||=||Interest earned on principal|
|1||6%||x||$ 1,000.00||=||$ 60.00|
|2||6%||x||$ 1,060.00||=||$ 63.60|
|3||6%||x||$ 1,123.60||=||$ 67.42|
|4||6%||x||$ 1,191.02||=||$ 71.46|
|5||6%||x||$ 1,262.48||=||$ 75.75|
|6||6%||x||$ 1,338.23||=||$ 80.29|
|7||6%||x||$ 1,418.52||=||$ 85.11|
|8||6%||x||$ 1,503.63||=||$ 90.22|
|9||6%||x||$ 1,593.85||=||$ 95.63|
|10||6%||x||$ 1,689.48||=||$ 101.37|
|Total Interest Earned||=||$ 790.85|
Compound Interest + Time = BFFs
The great thing about compound interest is that if you start early enough, you don’t have to invest as much into the principal in order to build wealth.
Take a look at the chart below. The person who started invested at 25 ends up with more money than the person who invested more money each month, but started 5 years, and 10 years after them. That’s the magic of compound interest. By consistently investing, even a small amount, over time that money grows “on its own”.
Interest can be compounded daily, monthly or quarterly. The more frequently interest is added, the better your account will look in the long run. The longer you leave money in your investment accounts, the larger it’ll grow over time. And, the more you add to your principal, you’ll earn even more interest. By adding as little as an extra $100 a month to the principal amount (that $1000 you initially invested) your money would grow exponentially as the months and years go by. See for yourself! Try some different financial scenarios in this compound interest calculator to see how quickly your money can grow.
The bottom line is, regardless of how little or how much you’re able to invest, compound interest works no matter what amount is in your investment account. If you’re debt-free, it’s absolutely critical that you start investing as soon as possible, and put that compounding interest to work.