Unfortunately, money doesn’t grow on trees and in the midst of the growing volatility and uncertainty that has plagued the global economy during recent years, the importance of compound interest has become more crucial than ever before. It is the one aspect of personal finance that can lead to a luxurious retirement or a financial disaster. Understanding compound interest and how it affects your personal finances is critical in the “survival of the fittest” of this challenging economy. Everyday I see people depositing money into basic chequing accounts at their local bank – these account pay almost no interest! If you look at what an online bank like Tangerine has to offer in terms of high interest rates, you can see pretty quickly how fast these percentage points can add up!
What is compound interest?
Compound interest is interest that builds upon itself. This means that if you invest $100 into a savings account that provides a interest rate of 5% annually (okay this is figurative, there isn’t any real savings account that will give you 5% annually!), you will have $105 by the end of the year. It seems like nothing, but by the end of the next year, however, you will have 110.25. This is because 5% of $105 is 5.25. With compound interest, the interest rate is applied to the full amount of the previous balance, including the amount that was previously added by the interest rate. When you begin to understand this simple concept, the importance of compound interest rate starts to become clear.
Where can Compound Interest work against you?
Credit card companies use compound interest rates to their advantage in advertising seemingly low rates (although I can’t say 19.99% is low). Each month, 1/12 of the annual interest rate is applied to the remaining balance on your credit card. The next month, that same portion of the interest rate is reapplied to the previous balance. In the end, you will typically pay a higher percentage of your original loan than the advertised annual percentage rate (since the interest isn’t actually charged on an annual basis). As a result, a large portion of your monthly payments will actually begin paying off the interest on your loan rather than just focusing on your total balance. This is why so many people find it nearly impossible to get out of debt.
Where can Compound Interest Work for you?
Enough about the dark side of compound interest, let’s talk about the good side – Compound interest can also be used to your advantage. As mentioned before, if you invest a certain amount of your money into a savings account (or other investment vehicle) that accrues interest, that interest rate will be applied every year (or whatever time frame your account was set for) in addition to the interest that was already gained. This money grows after the bank actually borrows some of your money, invests it in a loan, and then provides you with an interest rate as part of your share in their return on the loan’s interest rate.
It is super important to note that compound interest is more effective in the long-term. That is, you won’t be seeing any glorious results in one years time. I’m talking about 10 to 20 to 30 to 40 years until you see some impact (especially if your interest rate or rate of return isn’t very high). If debts are paid off quickly, the total percentage of interest paid will be much lower than if years are spent to pay it off. The same is true for investment plans. If the money deposited in an investment account is withdrawn before its 5 year anniversary in most cases, the interest earned will not reflect a significant change. However, if the interest is allowed to grow for a number of decades, it can provide a very lucrative retirement fund. Timing is one of the most important aspects of compound interest, which is why investment accounts are a highly recommended choice for young people. The following chart details a $1000 investment over a twenty year period with varying return on investments (from 5-10%).
photo credit: ponderingmoney.com
So start young and start now!!! And don’t withdraw! This magical compound interest can work for you with dividend stocks too, provided you don’t sell them.
If you want to learn more about how to make compound interest do the heavy lifting when it comes to your net worth, check out our RRSP vs TFSA comparison so that you know how to shield your interest gains from the tax man.
Readers, do you “do the” compound? If so, when did you start?