The Magic of Compound Interest

Firstly I'd like to apologize to Canadian readers because I couldn't find any pictures of Canadian money growing on trees LOL.

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?

Money Growing On Trees Pictures, Images and Photos

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%).

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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? 


  1. SavingMentor on October 24, 2011 at 8:24 am

    Don’t forget another area where compound interest can hurt you big time: your mortgage! That sucker is costing you big time in compound interest the longer you delay paying it off!

    Unless your mortgage interest rate is paltry, paying it off gives you a guaranteed, compounding, tax free return on your money. It also allows you to build up home equity which you can later use to invest using your HELOC if you see a good investment opportunity and then that money becomes a tax deductible investment loan!

    I say if you don’t see any investment opportunities or don’t like the current state of the markets (especially if they are high) – then pay off your house and get paid to wait for a better time to invest. Just make sure you have a plan for accessing your money quickly so when a good (but carefully thought out) investment opportunity arises, you are ready to pounce.

    So far I haven’t actually taken money out of my mortgage to invest, just put lots of extra money on the mortgage and getting paid to wait because I haven’t see the right investment opportunity come along. Maybe someday.

  2. jesse on October 24, 2011 at 11:06 am

    Also good about compounding: the more you save off your bottom line, the more you save. Simple!

    (And if you can let me know where to get those 10% returns that would be great k thx)

  3. Dividends For The Long Run on October 24, 2011 at 3:05 pm

    Even better than a dividend stock is a dividend growth stock, one which increases its dividend every year. Not only is there compounding taking place but the rate at which it occurs increases in addition to the size of the principal.

  4. retirebyforty on October 24, 2011 at 3:21 pm

    I think dividend stocks are the way to go these days. The 1% interest we get in the saving account isn’t going to cut it and the compound is too slow.
    Sorry, I couldn’t use your ING referral. I think it only works for a Canadian account. 🙁

  5. T.M @ My University Money on October 24, 2011 at 8:19 pm

    I’m constantly amazed by compound interest. I’m not a math guy, but I can definitely get behind these figures! My favourite quote on the topic is when Einstein said, “Compound interest is the most powerful force in the universe.” If anyone would know about powerful forces it’s that crazy genius!

  6. Kevo on October 25, 2011 at 6:12 am

    Yeah, I’m with Jesse on this one; show me the 10% returns? Those are pretty graphs and all, but they’re also way overly optimistic. Rates are absolutely horrendous, good luck getting even 2% off of a CD. Also, I’ve yet to see anyone factor in the depreciation caused by an inflation loss of say 1% / year.
    …Not that any of this is stopping me from trying :p. I just don’t think my chances are that good!

  7. Miss T @ Prairie Eco-Thrifter on October 25, 2011 at 8:55 am

    Great post. I am all for making compounding work for you and not against you. I too look to dividend stocks as the way to go. Not only can you make interest on your investment but you also get the bonus when dividends are paid on that growth. Great warning about the credit cards though. It reminds us how interest can hurt us too.

  8. Robyn @ Our Backyard 2 Yours on October 25, 2011 at 1:12 pm

    5% would be great! I guess the key is to stick with it. Love the post!

  9. young on October 25, 2011 at 5:41 pm

    @Robyn- Thanks Robyn 🙂

  10. young on October 25, 2011 at 5:42 pm

    @Miss T- Thanks Miss T! Glad you like it 🙂 Yes, I agree, with dividend stocks churning out some great dividends, it’s hard to decide to plunk that money down into a GIC. However it definitely depends on when one needs that money, right.

  11. young on October 25, 2011 at 5:50 pm

    @Kevo- LOL, like the comic. 🙂 Yes you’re right, I forgot to factor the inflation loss of 1% a year (well, more realistically it’s 2-3% a year). Rates are definitely horrendous right now (what, 1.75% if we’re lucky?). I think the point I was trying to get across is to invest in e-funds or dividends etc. that pay you back.

    For example, HSE (which I have yet to buy, but it went from $22 to $25 already!), was giving out a dividend of around 5% at $22. If you DRIP (I’ll have a post explaining this soon) your returns, you get 5% a year and if you sell it at a much later date (provided this company continues to pay dividends 20 years from now) you will have compound interest working for you (with DRIP). With that, I would think that a 10% return might be feasible, if one bought a dividend stock at the near bottom.

  12. young on October 25, 2011 at 5:51 pm

    @T.M.- Einstein never ceases to amaze me! He was so well versed in a variety of subjects 🙂 even personal finance LOL.

  13. young on October 25, 2011 at 5:59 pm

    @retirebyforty- Definitely 🙂 But I park my 1% in savings account for emergency stuff or short term stuff of course. I am horrified at my dividend portfolio right now LOL.

    No worries it was very sweet of you to try! I will still think of you, Mrs. RB40 and baby RB40 when I reach the top of Mt Kili 😉

  14. young on October 25, 2011 at 6:00 pm

    @Dividends For the Long Run- Of course! However there’s not that many of those puppies hanging around. I like the solid Dividend Players like FTS who have consistently increased their dividends for eons. I am now paying Fortis for my natural gas so I’m supporting my own investment haha.

  15. young on October 25, 2011 at 6:01 pm

    @Jesse- Haha, here! *pulls 10% return out of magic hat*

  16. young on October 25, 2011 at 6:04 pm

    @SavingMentor- Ughh! Yes! You’re right. It’s a huge factor. There’s always been that debate as to whether to invest your money back into your mortgage paydown or invest it into your investments. I like the idea of doing both (which is a balanced and egalitarian way haha). Are you planning to use the HELOC and Smith Maneuvre? (or do you already do this).

  17. Wayne McCombe on October 25, 2011 at 6:43 pm

    Paying off your mortgage does not yield you a return, it only saves you interest that you would have paid. Referring to it as a “guaranteed compounding return on your money” makes it sound like your mortgage is an investment when it is not, ignoring property appreciation, the best return you can get on a mortgage is 0% if you pay it all off the day you apply for it.

  18. Driscoll Ford on August 7, 2012 at 3:32 am

    The length of time you can leave your money to compound. The longer your money can remain uninterrupted, the bigger your fortune can grow. It’s no different than planting a tree.

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