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“The most powerful force in the universe.” “The greatest invention in the history of mankind.”
Many people claim that Albert Einstein said these words about compound interest. Whether he did or not, one thing rings true.
When considering a wealth building strategy, compound interest is a very powerful savings tool. Read on to learn all about compounding and how best to reap the rewards.
What is compound interest?
Compound interest accumulates your money at an accelerated rate. It’s interest on top of interest: Your deposits earn interest, and interest earns interest too.
This can lead to incredible growth over time.
On the other hand, simple interest corresponds to interest on the initial capital only, year by year. Prior interest is not taken into account.
Let’s say – hypothetically – that you deposit $20,000 into a high interest savings account which is compounding 2.80% interest. If the account remained at this rate for five years, your savings would grow like this:
|Year||Initial balance||Interest earned||Final sale|
Now let’s see what simple interest would look like at the same rate, over the same period, for comparison.
|Year||Initial balance||Interest earned||Final sale|
The difference between the $22,961 with compound interest doesn’t seem much more than $22,800 with simple interest. But advance to the end of 23 years in this scenario.
With compound interest, you will have almost double your initial investment for $37,746when with simple interest you just watch $32,880. By the end of the 50th year, compound interest will have accrued $79,558vs $48,000 with simple interest over the same period.
Now imagine the power of compound interest if you made regular contributions to that savings account.
Compound interest and savings
Here’s the good news: compound interest is far more common than simple interest when talking about savings. There are several types of savings vehicles you can open to make compound interest work for you.
Guaranteed investment certificates (GICs) are probably one of the safest places to keep your money and watch it grow. GICs offer guaranteed high interest rates, but lock in your funds for a fixed term.
These terms vary from 90 days to five years or more, and there are penalties for early withdrawal.
Once the term is over, you have the option to renew and grow your money in the GIC or withdraw it. All previous accruals will carry over to the next fixed term.
The locked-in nature of GICs can be restrictive, especially if you plan to open an emergency savings account that you’ll need quick access to.
You also won’t be able to deposit any more funds into the GIC until it matures and needs to be renewed.
High Yield Savings Accounts will give you the flexibility to withdraw and deposit funds whenever you want, and the accounts offer solid returns over time.
To keep your short-term savings more nimble, a high-yield savings account might work better.
Be like Buffett
When it comes to successful investing, American investment giant Warren Buffett is a shining example of how you can grow your money through compounding.
“My wealth comes from a combination of living in America, some lucky genes and compound interest,” he once wrote (CNN).
And if you look at examples of Buffett’s portfolios, you’ll notice that he’s mostly invested in dividend-paying stocks, which provide another form of capitalization.
My wealth came from a combination of living in America, some lucky genes, and compound interest. —Warren Buffett
One of the best things you can do, if you’re okay with a little risk, is to invest in a mix of stocks, mutual funds, and ETFs that pay dividends. A popular ETF, or exchange-traded fund, in Canada is the Vanguard VFV, which tracks the US S&P 500 index.
The reinvested dividends you earn will generate further dividends, and the compounding dance continues.
Let’s take a look at historical data from the S&P 500 as an example. Say you invested $100,000 from 2013 to 2017 in an index fund that mimics the S&P 500.
The following table shows what this would look like without (w/o) and with (w) reinvestment of dividends:
|Year||% gain without||% Gain w||Final balance without||Ending balance w|
Dividend reinvestment cushioned your loss in 2015 and allowed you to nearly double your initial investment in five years.
If you regularly contribute to your stock portfolio in a well-thought-out approach and reinvest your dividends, the average growth of your portfolio has the potential to look very green.
In the long run, you may not see the same kind of growth that Buffett has over his career. But he can attribute his great success to smart investments and the power of capitalization. And you can do the same.
If investing on your own is intimidating to you, there are plenty of new technologies out there that do the heavy lifting for you and reduce the cost of investing fees.
Wealthsimple is an automated investing service that makes automatic adjustments to your portfolio in response to risk, so you don’t have to worry. But if you still want to discuss your investment mix, portfolio managers are there to answer your concerns.
Whether you’re saving for the short term or investing for the long term, compound interest is your best friend. So give him a hug and let him work for you.