The Snowball Effect of Compound Interest When Saving

You’ve got so many competing claims on your money: paying off student debt, rent or mortgage payments, credit card bills, and goals such as down payments, cars, weddings, or kids. Saving for retirement is barely on the radar for many Canadians, according to a recent Scotiabank poll, especially in the 18-35 age range.

But it’s those younger people who should really be doing their best to put aside even small amounts, in order to take advantage of the power of compounding, or growth on your growth.

While compounding can work with stocks in terms of capital gains, let’s look at how it works with fixed-income securities that earn interest.

What is simple interest?

Interest is the fee paid for borrowing money. When you get a loan, you pay the lender a percentage of the loan in interest.

When you “loan” your money to a financial institution, for instance, by buying bonds or guaranteed investment certificates (GICs) or by putting your money into a high-interest savings account (HISA), you are paid interest on the amount.

Simple interest is based on the original, or principal, amount of a loan or deposit. It is calculated by multiplying the principal by the interest rate by the amount of time (which can range from daily to monthly to yearly or other time frames, depending on the terms you agree to).

Example

For example, say you invest $100 (the principal) at a 5% annual rate for one year. The simple interest calculation is:

So, after a year, you have earned $5 simple interest for a total of $105. After two years, you would have $110. And so on.

But if you don’t spend that $5, you can add it to the amount you earn interest on, resulting in compound interest.

What is compound interest?

Earning (or paying) interest on top of interest is called compound interest.

For example

In the example above, if you left that $5 alone instead of spending it, the second year, you would be earning interest on $105 instead of $100.

Compare this with simple interest, where after three years, you would have:

Longer time frame

While the difference between simple and compound interest in this example using a small amount and a brief period of time seems tiny, the difference can be much larger with larger amounts, especially over a prolonged period, like the number of years between your deposit and when you retire.

For instance, if you invested that $100 at age 20 (assuming the same 5% yearly interest rate) and let it sit without touching any of the interest earned until you retire at 65, you would end up with $898.50, with a total interest earned of $798.50.

Adding to the initial amount

If, rather than just leaving the initial $100, you keep adding to the pot, say with $100 every year, at the same amount of yearly interest rate, without touching any of the interest earned until you retire at 65, you would end up with $16,868.52, with a total interest earned of $12,268.52.

More frequent compounding periods

If your investment calculates interest more often than yearly, you can earn even more interest. For instance, taking the example above where you start with $100 and add $100 annually with an interest rate of 5%, but interest is calculated monthly, at 65 with no withdrawals, you would end up with $17,447.82, with a total interest earned of $12,847.82.

You can try different variables with the Ontario Securities Commission’s compound interest calculator.

This is one reason why starting to save early is so critical and why taking money out of your savings can harm your longer-term financial growth.

Undoing your hard work

Whether you invest your money in a tax-free savings account (TFSA), a registered retirement savings plan (RRSP), or put your money into a HISA, the temptation to withdraw funds when things get tight can be strong.

But this can undo the “snowball” effect of compounding by making the amount that you earn interest on smaller.

In the example above, if you withdraw the $5 you earned in the first year, your scenario would look like this:

So, in year three, you would have earned $110.25 rather than $115.76 if you had not touched the money. Again, these are tiny amounts for simplicity’s sake, but in real life, if you are working with several thousand dollars over many years, that amount you lose out on can be substantial.

Compounding and debt

Compounding can also work against you when you are borrowing money.

For instance, if you don’t pay off your credit card’s full balance, you will be charged interest on the amount still owing on that month’s bill. Next month, if you still don’t pay off your full balance, you will be charged interest on that month’s amount outstanding, plus the amount still owing from the previous month, including the interest you owe. So, it’s not just interest on purchases, but interest on the interest you’re on the hook for.

The takeaways

Compound interest is an asset to savings and investment strategies, earning interest on interest and building funds over time. The more time funds can sit untouched, the better, allowing compounding to maximize your savings’ growth. However, withdrawing money can stunt your longer-term financial goals and take away the advantage of compounding. Remain mindful of the benefits of compound interest when deciding what to do with your savings. It can make an enormous difference down the road, especially at retirement.