Does Compounding Capture Your Interest?

Maybe it’s the rising price of goods and services, or the higher rates charged for mortgages, credit cards and other types of debt. Or it could be something else, but the reality is that financial challenges will always surface in everyday life.

While some factors are out of your control, you can take certain actions to improve your finances. For instance, consider investing regularly to help grow your wealth over the long term, or being mindful of any non-essential expenses. You can also take advantage of compound interest.

Understanding Compound Interest

With higher inflation comes higher interest rates to help cool off an overheated economy. That’s why it may cost you more these days to pay down your debt. On the flipside, savers have welcomed rising interest rates because, after decades of ultra-low rates (not too long ago, rates were sitting at or near zero), interest-bearing investments are finally providing some meaningful income.

From guaranteed investment certificates (GIC) to high-interest savings accounts (HISA) and more, the attractive interest rates they are now paying reflect the fact that the Bank of Canada raised its benchmark interest rate seven times in 2022 alone, to help slow the economy and calm inflationary pressures.

So, if you hold GICs and/or a HISA at your financial institution, you can put a dent into soaring costs by earning more interest income. But it gets better. When you earn interest on such investments, you may reinvest the interest as it’s paid, which means your interest will actually start earning interest as well. In a nutshell, that’s the concept of compound interest, and it can help you grow wealth faster.

Compound Interest in Action

Here’s a simplified example. Let’s say you invest $20,000 in a five-year GIC that pays 4% annually. Your principal amount will generate $800 of interest income after the first year ($20,000 x 4%). If you choose to reinvest the $800 in this GIC that’s yielding 4% per year – rather than take it as a cash payout – then that $800 will also earn 4% annualized interest. This means that for the second year of your GIC, you will receive $832 in interest ($20,000 original investment + $800 interest earned in year one x 4%).

For each year of your GIC, the accumulated interest you collect will continue to earn 4% annually on its own, in addition to your $20,000 original investment. The same principle applies to a HISA, where interest is typically calculated daily and then that interest starts to generate its own interest income. There’s the magic of compound interest as an effective wealth builder over time.

INvestment Flexibility

Here’s one more notable benefit of compound-interest savings vehicles like GICs and HISAs: you may hold them in registered plans or accounts – such as the RRSP, TFSA, RESP, RDSP and RRIF – that each have their own tax advantages, allowing you to retain more of your hard-earned money. Your Investment Advisor can work with you to help determine which account(s) to utilize.

Although the cost of living continues to rise, you can help keep pace by taking advantage of compound interest. It doesn’t even require you to invest a large lump sum. Some plans allow you to get started with as little as $50, and then you can add to your investment whenever the money is available. Consider a pre-authorized contribution (PAC) plan that automatically invests for you on a specific schedule (e.g., $100 per month). PACs can be a convenient way to invest regularly and allow compounding to build your long-term wealth.