Investing can be complicated, but one of the most important and simple things to understand when you start investing is compound interest. The rumor is that Albert Einstein once called compound interest the eighth wonder of the world, I doubt that’s true, but it definitely fits! It's so powerful that saving even small amounts early in life can lead to huge gains later, making it one of the easiest ways to reach financial freedom. When you save and invest with compound interest, your returns are reinvested into your investment- so they can earn even more compound interest! This snowball effect means that your original investment grows exponentially over time. And thanks to compounding, those earnings also generate their own return!
This blog post will explore what compound interest really is, how it compares to simple interest, why it’s important to start investing early, as well as how you can use it to increase your savings and grow your investments for retirement! We also include multiple examples of what compound interest can do for you throughout the post.
- What is compound interest?
- Compound Interest vs Simple Interest
- Why is it so important to start investing early?
- What types of investments have compound interest?
- How can I take advantage of compound interest?
- - Start Investing Early
- - Contribute Frequently
- - Increase Your Contributions
- - Increase Your Rate of Return
- - Don't Pull Money Out
- - Reinvest Dividends
- Calculate Compound Interest
Compound interest is interest that has accumulated during a period, which is then added on the principal amount for the interest calculation for the next period. For this article, we are talking about compound interest on investments, but compound interest can also work against you on things like credit cards. For that reason, you should be paying off credit card debt before starting your investment journey.
Compound interest allows your investment to grow at a faster rate, as it has more money to work with. Over time, this can result in a large increase in the initial investment amount. The longer the money has to compound, the greater the return.
Compound interest can be compounded at different intervals, such as daily, weekly, monthly, quarterly, semi-annually, or annually. The more often interest is compounded on your investment, the better. Some investments, such as some in the stock market, don’t earn a set interest rate that is compounded at a regular interval. It is constantly compounding, and the return goes up and down. Later in the article we will show various examples of the power of compounding in the stock market over the last 40 years. Other investments in the stock market may provide dividends, which is an example of compound interest IF you re-invest the dividends.
The difference between compound interest and simple interest is that compound interest increases exponentially as time goes by due to reinvesting earnings from previous periods into subsequent periods. In contrast, simple interest is only earned once at the end of each year or period and is not included in subsequent periods. This means that if you have an account with compound interest, your money will grow at a faster rate than if it had simple interest.
As an example of simple interest, let’s assume you purchased a 20-year investment for $10,000 that paid 10% simple interest per year. This would return $1000 per year for 20 years (10% of $10,000 every year), giving you a total of $20,000 interest earned on your $10,000 investment after 20 years.
Now let’s compare that to compound interest, we will keep the same assumption of buying an investment for 20 years that returns 10% per year, but this time it is compounded monthly. The first year you earn $1047, but the next year you earn 10% of $11,047 instead of $10,000. So, the year after that you would earn $1158 interest instead $1047, and so on. This gives you a total of $63,280 in interest earned over 20 years, a 216% increase.
The longer your investments have to compound, the more exponential growth you will see. The power of compounding interest really comes when you have a long-time horizon to let it compound. Saving even small amounts over a 30-year period will really add up in the end. In fact, if you start saving for retirement at age 25 instead of age 35, you'll have about twice as much money saved up by the time you retire!
As an example, if someone was able to start investing just $200 per month at the age of 20 with an annualized return of 7%, by the time they are 65 they would have $758,518 saved, with $650,518 of that being interest earned!
In comparison, let’s assume another person waited till they were 40 before starting to invest. If they invested the same $200 per month and got the same 7% per year return, they would only have $162,014 by the time they turned 65. If they wanted the same $758,518 by 65, they would have to invest $936 per month! That’s a big difference! We will include more visual examples below.
That's why it's so important to start investing early in your life!
There are many different investment vehicles that can reward you with compound interest. We will list a few examples so you can find one that meets your investment style. It’s important to check individual investments yourself before investing, to understand if it compounds, and if so, how often is it compounded/paid.
- High Interest Savings Accounts
- Certificate of Depostits (CDs) or Gaurenteed Investment Certificates (GICs) for Canadaians
- Stock Market (Capital Growth)
- Stock Market (Dividend Reinvestments)
- Real Estate Investment Trusts (REITs)
- Mutual Funds
- Real Estate
You can take several steps to take full advantage of compound interest, some of which we have already talked about such as starting to invest early. In this section we are going to further explore more ways to take advantage of compound interest, as well as go over a few more examples.
As mentioned previously, starting to invest early is one of the best ways to take advantage of compound interest. Giving your investments as much time as possible to compound will insure you get the best effect from compounding. The time below shows the difference between investing for 20 years and investing for 40 years, quite the difference!
Just as important as starting early, is to contribute frequently. The best way to do this is to automatically add money to your investments at consistent time intervals, such as when you are paid from your job. Many brokers offer services that automatically invest a certain amount every so often, so you don’t have to try and remember.
One of the best ways to take advantage of compound interest, especially early on, is to increase the amount you invest. This is often overlooked by investors, who stick to a set amount of money that they contribute each month. However, compound interest will increase your savings much faster if you increase the amounts you put in over time. A couple good ideas are to redirect raises you get at work directly to your investments, or if you get a bonus at the end of the year. Or perhaps you just paid off your vehicle, it might be worth thinking about putting what would have been the payment towards your investments instead. Another option is to do a budget and see where your income is going. You might find a few extra dollars here or there that you can invest.
In the image below we look at the difference between contributing $100 per month and $200 per month. In both cases it assumes you earn 7% interest per year, compounded monthly, and that you’re starting with $10,000. As you can see from the graphs, despite only contributing $48,000 more over 40 years, your investments are worth $688,076 compared to $425,595! That’s a difference of $262,481 after 40 years.
I purposely use smaller numbers to try and encourage newer investors that may not have a lot of spare money to start investing that it’s still worth it. Some of my readers may already be investing quite a bit, so here is an example of increasing monthly contributions to $1000 from $700, again starting with $10,000 and earning 7% per year. As you can see, after 40 years you would have contributed $346,000 and $682,000 respectfully, and your investments would be worth $2,000,483 and $2,787,927. By contributing an extra $300 per month, you make an extra $451,444 in interest!
Another great way to take advantage of compound interest is to increase your annual rate of return, though that's often easier said than done. There are different types of investors, but they generally fall somewhere on the spectrum of those that keep all their money in a savings account earning a very low return with no risk, those that invest in broad index funds with minimal risk, or those that buy individual stocks trying to beat the index. Although increasing your rate of return is a great way to increase your earnings long term, it's important to understand your limitations. Most people that invest in individual stocks end up underperforming the general market long term. For that reason you may be better off putting your money in a simple index fund, and focus your time on increasing your contributions instead of researching stocks.
In the following graph I will compare an investment over 40 years. We will invest $400 per month, which will be compounded monthly. In the first graph we will earn 2% interest (representing a savings account), in the second we will earn 7% (representing long term average return of a broad index fund including some bonds), and in the third we will earn 10.5% (representing the long-term return of the S&P 500). Of course, we can’t be sure these returns will continue in the future, but this will give an example of how the rate of return affects compounding interest.
As shown, the rate of return makes a massive difference, and even small increases make the result astoundingly larger. With a 2% annual return you end up with $316,014, with a 7% annual return you end up with $1,213,039, and with a 10.5% annual return, you end up with a staggering $3,602,408. So, for those of you hoarding money in a savings account that barely pays you anything, you might want to change up your investment style!
Unless absolutely needed, you should keep your investments invested. Many people have pulled out all their investments because they thought the market was at all-time highs, only to see it explode over the next few years. Others pull their money out after stock market recessions, which is the worst thing you can do (unless you put it in a bad investment to begin with). You cannot take advantage of compound interest if your money is sitting on the sidelines (in fact, with money sitting on the sidelines earning nothing, you are actually losing value due to inflation, which is compounded).
A lot of investors like to focus on dividend investing, but to take full advantage of compound interest with dividend investing, you NEED to reinvest those dividends! The best way to do that is by setting up a dividend reinvestment plan (DRIP). This allows you to automatically use the dividends to buy more shares, which ensures the money is reinvested as soon as possible while also saving you commission fees. The only caveat is that you must receive enough in dividends to purchase a new share, otherwise the money will just be deposited into your account.
As an example of the important of reinvesting dividends, we will look at a portfolio of the 5 big banks in Canada. Our portfolio will be split evenly, with each bank being 20% of the total portfolio, we will start with $10,000, with no contributions. From 1996 till now, you would end up with $127,978 if you didn’t reinvest dividends. Not bad, but if you would have reinvested dividends, you would have ended up with $337,271!
Interested in seeing for yourself how much you could save if you started today? The best way to calculate compound interest is to use an online calculator, such as the one at this link.
This is my favourite calculator, as it allows you to input initial investment, regular additions, interest rate, how often interest is compounded, and your time horizon. It then tells you the value of your total result, as well as how much of that is interest, with a nice graph showing you how exponential compound interest really is. There are many calculators out there though, and a simple google search will lead you to many.
Compound interest is an extremely important tool for investors, and it's one of the main reasons why it's so important to start investing early in your life. By starting to invest at a young age, you give compound interest more time to work its magic and grow your money. In addition, compound interest can help protect you from inflation, which can erode the value of your savings over time.
We’ve gone over what compound interest is, why it’s important, how to earn it, and tips to maximize it... now it’s time for you to take action! Let us know how you plan to take advantage of compound interest below!