You can grow the money you save by investing it to earn a return. You can make your money grow faster if you also invest the money you earn along with the money you started out with. This is called compounding. Compounding works for both guaranteed and non-guaranteed investments.
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What is compound interest?
Interest is one of the ways you can make money from investing. There are two types of interest: Simple, and compound. Both are based on the amount you start with — known as the principal. Interest is calculated as a percentage of the principal amount.
Simple interest is calculated on the principal amount only. If you start with $100, and you earn 5% simple interest annually, you will have $105 at the end of the first year. At the end of the second year, you will have $110. After the third year, you’d have $115, and so on. Each year, 5% of the original amount would be added.
Compound interest is calculated on the principal and any interest you’ve already earned. If you started with $100 and earn 5% compound interest each year, you’d have $105 after the first year. At the end of the second year, you’d have $110.25. After three years, you’d have $115.76. Compound interest reinvests the interest each year, so that it earns you a little more money.
This example above might not seem like a lot — adding an extra quarter to your bank account won’t buy you much — but as you continue to add to your savings over time, compound interest can really add up. Depending on the account, compound interest could be calculated weekly, monthly, or annually.
The younger you are and the longer your investing time horizon, the more compound interest can work its magic. The more time you have, the higher your reward. But remember, it’s never too late to get started.
How does compounding work for investing?
Compounding is a simple idea: the investments you make will earn a return each year. If you reinvest these earnings by putting them back into your original investment, you’ll grow your money more quickly.
Whether you invest in bonds, stock, or other asset classes, you can put the power of compounding to work for you.
Try your hand at calculating how your money could grow through compound interest. You just need to know how much you’re saving (the principal) and what the interest rate will be.
To see how your money grows with compound interest for longer than 4 years, use compound interest calculator.
How does compounding work for guaranteed investments?
Investments like savings accounts, GICs and bonds pay interest. With these types of investments, you know exactly how much money you’re going to earn. Guaranteed Investment Certificates (GICs) pay a guaranteed rate of return, so you can invest knowing how much you will earn by the end of a specific period of time.
For example, imagine you invest $10,000 for three years in a GIC that earns 2.5% interest compounded annually. Here’s how your investment would grow over that time frame:
| Year | Value at start of year | Interest earned | Investment value at end of year |
| 1 | $10,000 | $250 | $10,250 |
| 2 | $10,250 | $256.25 | $10,506.25 |
| 3 | $10,506.25 | $262.65 | $10,768.90 |
This type of investment can be useful if you have money you intend to set aside for a specific purpose in the future but you want it to be able to grow while you’re not using it. For example, if you plan to do a home renovation in a few years that will cost around $30,000, you could put money in a series of GICs:
- $15,000 in a 3-year GIC
- $10,000 in a 2-year GIC
- $5,000 in a 1-year GIC
By the end of the three years, you would have more than the $30,000 you started with, due to the interest earned on each GIC. Each GIC will compound at their own interest rate, which might be different from the others. This is sometimes called a GIC ladder — each GIC gives you another step in your saving progress. The trade-off for investments like these is that you may be required to leave your money in the GIC for the full term, in order to earn the guaranteed interest. Some GICs are refundable, meaning you can withdraw the money earlier than the end of the term, but these may come with lower interest rates than fixed-term GICs. Learn more about GICs.
Any investment held in a registered account like a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA) your earnings can grow tax-free while your money stays in the account.
How does compounding work for non-guaranteed investments?
A non-guaranteed investment means that you won’t be able to predict how much it will grow, or how fast. You can still benefit from compounding by reinvesting your earnings on non-guaranteed investments like stocks, mutual funds and exchange-traded funds (ETFs). Let’s say you have a non-guaranteed investment, such as investing in shares in a company. If the company makes a profit, you could receive dividends — a return on your investment. If you re-invest your dividends to purchase more stock, that’s compounding. For example, let’s say you have $10,000 to invest for three years, and you decide to invest this money in a mutual fund. Your investment gains 5% in the first year, loses 1% the second year and in the last year it gains 7%. The investment pays you income each year in the form of dividends. If you decide to reinvest your dividends into more units, here’s what you’d gain or lose each year:
| Year | Value at start of year | Gain (loss) | Investment value at end of year |
| 1 | $10,000 | $500 | $10,500 |
| 2 | $10,500 | $(105) | $10,395 |
| 3 | $10,395 | $727.65 | $11,122.65 |
In this example, even though the investment showed a loss during the second year, after three years there was still an overall gain due to the two years of growth.
What is the rule of 72?
The rule of 72 is a quick way to estimate how long it will take you to double your money through compounding. You simply divide the number 72 by the annual interest rate you plan to earn on your investment. Although the rule is not always exact, it generally works as long as the interest rate is less than 20%. If your investment return is not guaranteed, your doubling time may change if the expected return changes. For example, let’s say you invest $10,000 at an expected annual return of 5. Using the rule of 72, you will double your money in a little over 14 years if you let your returns or distributions compound (72 divided by 5 = 14.4).
When compounding can cost you
Compound interest can also be used to calculate interest on debt you owe, such as your credit card balance. Many kinds of debt charge interest on the amount you don’t pay. If you don’t pay off your balance one month, you’ll be charged interest on your full balance owing, including the interest added to your account last month. Learn more about paying down debt and calculating how much you owe.
Summary
Compounding is when you re-invest the money you earn from your savings or investments.
- There are two types of interest: Simple and compound.
- Simple interest is only earned on the principal.
- Compound interest is earned on both the principal and any interest earned previously.
- Compound interest grows faster than simple interest, because simple interest is only earned on the principal.
- Guaranteed investments like GICs use compound interest.
- You can also benefit from compounding by re-investing earnings on investments like stocks, mutual funds, or ETFs.
- The longer your time horizon, the more benefit you’ll see from compound interest.
