Grow your savings with compound interest
If you invest the money you save, you can make it grow by earning a return on your investment. Your money will grow faster if you add interest income that you earn (your return) at the amount you originally invested. This is called compounding interest. Whether you invest in guaranteed or non-guaranteed investments, you can capitalize the interest you receive through compound interest.
How Compound Interest Works
Simple Interest : If you have an investment of $100 to start with and you earn 5% interest annually for two years without reinvesting the interest income, after two years you will have $110. In other words, you will have the original $100 plus the $5 earned in interest for each of the two years your money was invested.
Compound interest : Your starting balance is recalculated after each year when you reinvest the interest you earn. With compound interest, you will have $110.25 after two years. In the first year, you will earn $5 in interest on your investment; this will bring your year-end balance to $105. This $105 will then be reinvested for another year at 5% interest, so you will earn $5.25 in interest in the second year.
The above example may not be spectacular. In fact, an additional 25 cents in your account will be added to yourbanking won't make much of a difference. However, over time, if you continue to save, compound interest can really add up.
How Compound Interest Works for a Guaranteed Investment
Example : You have $10,000 to invest for three years in a Guaranteed Investment Certificate at an interest rate of 2.5% compounded annually (i.e. your return is added to the investment at the end of each year). Here's what happens during the three years:
How Compound Interest Works for a Non-Guaranteed Investment
Investments such as savings accounts, guaranteed investment certificates and bonds earn interest. With these types of investments, you know exactly how much money you will earn.
You can also take advantage of compound interest by reinvesting your earnings in other types of investments such as stocks, mutual funds and exchange-traded funds. If you hold any of these investments in a registered account such as a Registered Retirement Savings Plan or a Tax-Free Savings Account, you may be able to reduce or even eliminate the tax you have to pay on your earnings.
Example : You have $10,000 to invest for three years. Because you have a high risk tolerance, you decide to invest this money in a mutual fund. You realize investment gains of 5% in the first year, losses of 1% in the second year and gains of 7% in the last year. Each year, you earn income from your investment in the form of distributions. If you decide to reinvest these distributions by buying more units, here are the gains and losses you realize over the three years:
Compound interest: the other side of the coin
Compound interest can also work against you, for example, if you don't pay your credit card balance in full. You are then obliged to pay interest on the outstanding amount. Then, if you don't pay your balance in full the following month, the interest you have to pay is calculated on the entire amount owing, including the interest charged to your account the previous month. In other words, rather than earning interest on interest as in the savings examples above, interest must be paid on interest when you have a debt.
The Rule of 72
The Rule of 72 is a quick way to estimate how long it will take you to double the amount of an investment through compound interest. Simply divide 72 by the annual interest rate applicable to your investment. Although the rule doesn't always give an exact result, it usually works well when the interest rate is less than 20%. If the return on your investment is not guaranteed and fluctuates, the time it takes to double the amount of your investment may also vary.
Example : The annual return you hope to earn on your investment is 6%. Under the Rule of 72, it will take you 12 years to double the amount invested (72 divided by 6) if you reinvest the interest income or distributions.
Things to keep in mind
The longer your investment horizon, the more your savings can grow.
What to do ?
Use our compound interest calculator to see how much small savings can accumulate over time.