Compound Interest: How It Works and Why It’s Amazing
By the Inspired Investor teamAugust 5, 2022
Find out why 'interest on interest' is important and how it can make your wealth grow faster.
It’s been said that Albert Einstein once called compound interest the “most powerful force in the universe.” Whether or not the wild-haired theoretical physicist was wowed by a savings strategy based on exponential math is debatable, but the value of compound interest is decidedly not.
What Is Compounding?
Compounding interest can be defined as “interest on interest.” It means earning interest on your initial savings and then reinvesting it so you can earn interest on the new total – the original amount plus the interest. Simple interest, on the other hand, is interest paid on your initial savings only.
Here’s a straight-forward example of compounding on a $100,000 investment that earns a guaranteed 2.5 per cent interest. (The example assumes annual compounding and no further additions to your savings.)
|Year||Value on January 1||Interest earned (2.5%)||Value on December 31|
As you can see, the longer your time horizon, the more significant the impact. It’s a perfect example of how slow and steady wins the race. For comparison, the above example using a simple interest calculation would result in your investment growing to $162,500 over 25 years ($2,500 of interest paid each year on your principal amount without reinvesting). That falls short of the $185,394.41 after 25 years with compounding.
Of course, it’s always important to think about the effects of inflation — the increase in the prices of goods and services over time — on investment returns, which can help you determine what investments are right for you. Over time, inflation reduces the purchasing power of your money.
While the above example is based on a guaranteed interest rate — something you may receive from a high-interest savings account, bond or Guaranteed Investment Certificate (GIC) — compounding can apply to other investments as well.
Compounding Investment Income
Individual stocks, mutual funds and exchange-traded funds (ETFs) can also pay income in the form of dividends1 and distributions, and compounding can come into play by reinvesting those earnings.
Here’s how it works. If you own a dividend-paying stock, you receive regular dividend payments. You can choose to keep that income or reinvest it to buy more shares2. By reinvesting the dividend payouts, you increase the number of shares or units you own, thereby increasing your potential future dividend payouts. Think of it as earning “dividends on dividends.”
Reinvesting distributions from mutual funds or ETFs that hold bonds or money-market securities can work in the same way. You can use the interest-income distributions you receive from a fund to buy more units, which would increase your future distributions because you’d own a higher number of units.
Remember, Compounding Also Works in Reverse
When your savings earn interest, you are on the receiving end of compound interest. But with personal debt like credit cards or car loans, it’s possible to end up paying compounded interest. For example, if you carry a balance on your credit card, the interest you owe will compound each month. Assuming you don’t make any payments, the interest owed on any balance you carry month-to-month would compound in the same way your savings did — steadily.
Finding the Space and Time
While it’s unlikely that Albert Einstein spent much time thinking about compound interest what with that theory of relativity likely taking up so much time (and space!), investors can be well-served by understanding the “powerful force” of compounding.
Investment advice is provided by Royal Mutual Funds Inc. (RMFI). RMFI, RBC Global Asset Management Inc., Royal Bank of Canada, Royal Trust Corporation of Canada and The Royal Trust Company are separate corporate entities which are affiliated. RMFI is licensed as a financial services firm in the province of Quebec.
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This article is intended as general information only and is not to be relied upon as constituting legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. Information presented is believed to be factual and up-to-date but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by Royal Bank of Canada or any of its affiliates.