You can grow the money you save by investing it to earn a return. You can make your money grow faster if you also investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition the money you earn (your return) along with the money you started out with. This is called compoundingCompounding A way to grow your money faster. Instead of spending the money you make investing, you reinvest it so it can grow.+ read full definition. Compounding works for both guaranteed and non-guaranteedNon-guaranteed Investments that do not guarantee what you will make. You could lose some or all of your money. Examples include mutual funds, stocks, real estate, gold and income trusts.+ read full definition investments.
How compounding works
- Simple interest – If you start with $100 and earn 5% interest annually for 2 years without reinvesting the interest you earn, at the end of the 2 years you will have $110 – the $100 you started with, plus $5 in interest for each of the 2 years you invest your money.
- Compound interest – Your starting balance is reset after each year when you reinvest the interest you earn, and after 2 years you will have $110.25 – in the first year you earn $5 on your investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition, giving you a total of $105 at the end of the year. This $105 is then reinvested for another year at 5% interest, earning you $5.25 for the second year.
The example above might not seem like a lot – adding an extra quarter to your bank accountAccount An agreement you make with a financial institution to handle your money. You can set up an account for depositing and withdrawing, earning interest, borrowing, investing, etc.+ read full definition won’t buy you much – but as you continue to add to your savings over time, compound interest can really add up.
How compounding works for a guaranteed investment
Example – You have $10,000 to invest for 3 years in a guaranteed investment certificate (GIC) that earns 2.5%, compounded annually (meaning your return is added to the investment at the end of each year). Here’s what happens in the 3 years:
|Year – Starting balance $10,000||Value at start of year||Interest earned||Investment value at end of year|
How compounding works for a non-guaranteed investment
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. You can still benefitBenefit Money, goods, or services that you get from your workplace or from a government program such as the Canada Pension Plan.+ read full definition from compounding by reinvesting your earningsEarnings For companies, its the money they make and share with their shareholders. For investors, its the money they make from their investments.+ read full definition on other investments, like stocks, mutual funds and exchange-traded funds (ETFs). If you hold any of these investments within a registered account like a registered retirement savings plan (RRSP) or tax-free savings account (TFSA) you may be able to reduce or eliminate the taxTax A fee the government charges on income, property, and sales. The money goes to finance government programs and other costs.+ read full definition you pay on your earnings.
Example – You have $10,000 to invest for 3 years. You have a high risk tolerance so you decide to invest this money in a mutual fundMutual fund An investment that pools money from many people and invests it in a mix of investments such as stocks and bonds. A professional manager chooses investments that match the funds goals for risk and return. You can redeem your fund units at any time.+ read full definition. 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 distributions. If you decide to reinvest your distributions into more units, here’s what you’d gain or lose each year:
|Year – Starting balance $10,000||Value at start of year||Gain (loss)||Investment value at end of year|
The cost of compounding
Compound interest can also work against you, like when you don’t pay off your credit card balance. You are charged interest on the amount you don’t pay. If you don’t pay off your balance next month, you’ll be charged interest on your full balance owing, including the interest added to your account last month. Instead of making interest on interest in the savings examples above, with debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date.+ read full definition you’ll pay interest on interest.
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 yearly interest rateInterest rate A fee you pay to borrow money. Or, a fee you get to lend it. Often shown as an annual percentage rate, like 5%. Examples: If you get a loan, you pay interest. If you buy a GIC, the bank pays you interest. It uses your money until you need it back.+ read full definition you plan to earn on your investment. Although the rule is not always exact, it usually 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 returnExpected return Estimated value of your investment in the future. Tells you the overall profit you might expect – either as income (interest or dividends), or as capital gains (or losses). Often expressed as a percentage.+ read full definition changes.
Example – Your investment’s expected annual return is 6%. Using the rule of 72, you will double your money in 12 years (72 divided by 6) if you let your returns or distributions compound.
The longer your time horizon, the more benefit you’ll see.
Use this compound interest calculator to see how even small amounts add up over time.