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“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” -Albert Einstein
Interest is money that borrowers must pay on their debts or that savers earn on their investments. When interest is added to the debt (loan) or the amount invested (principal), the added interest also earns interest until the debt is paid off or the investment is cashed out. This process of adding interest to the original loan or principal is called compounding.
Compounding interest works for you or against you, depending on whether you are a saver or a borrower. It creates profound consequences for savers and borrowers.
If you are a saver:
Investing money earns you money. You are being paid for the use of your money.
Compound interest means your savings grow over time.
The higher the rate of compounding interest, the faster you are making money; thus, increasing the value of your principal.
If you are a borrower:
Borrowing money costs you money. You are losing (paying) money every day you have debt.
Compound interest means that you must pay back more than just the principal portion of the loan.
The higher the rate of compounding interest, the faster you are losing money and adding to your total debt. Avoid high interest rates whenever possible.
Should I Pay Down My Debt or Allocate It to Savings?
Whether you are a saver or a borrower, you can use the Rule of 72 to estimate the positive or negative impact of compounding events. As an example, let's assume that your loan interest rate is 5% and you expect a 5% investment return. Let's also assume that your marginal tax rate is 40%.
$10,000 earning 5% compounding interest will double to $20,000 in 72/5 = 14.4 years
$10,000 borrowed at a 5% interest rate will cost you $20,000 if repaid in 72/5 = 14.4 years
Since loan interest is paid with after-tax dollars, the rate of return on each dollar put toward reducing the loan gives you an equivalent after-tax rate of return of 5%.
If the result of allocating money to savings is to be competitive, the compound interest earned must have a consistent yield, after tax, of at least 5%.
Given that any interest earned from your savings is taxable, in the above example you would have to get a 8.33% interest rate of return, before tax, on your savings principal.
While the amount or rate of compound interest is an important variable to understand, the frequency of compounding and the number of compounding periods also affect how compound interest accrues over time.
Frequency of Compounding
Interest can be compounded daily, monthly, quarterly, semi-annually or yearly. Financial institutions offer different frequencies of compounding, depending on the product. Generally speaking, a saver wants a higher frequency of compounding, while a borrower wants a lower frequency of compounding.
Number of Compounding Periods
The number of compounding periods is related to the term of the loan or the savings product. In other words, if you have a five-year car loan with monthly compounding, then there are 60 compounding periods.
Consistent investments over a number of years can be an effective strategy to accumulate wealth. Even small additions to your savings add up over time. This calculator demonstrates how to put this savings strategy to work for you and the power of compounding.
Note that your investments may be subject to tax if held outside of a registered account such as an RRSP. The cost of tax can reduce your compounded returns. The impact of tax is not considered in this calculation.
Information and interactive calculators are made available to you only as self-help tools for your independent use and are not intended to provide investment or tax advice. We cannot and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.