The Power of Compound Interest
April 21, 2021
Why do we invest our money? Well, one of the key reasons is compound interest – meaning, the money we invest today has the ability to grow if placed in the proper investment accounts. The idea is that if we invest $100 today at a 5% annual interest rate, it will grow to $105 in a year. If you then take that $105 and re-invest it yet again at 5%, in another year you will have $110.25, and so on. Making our savings earn more money is the fundamental reason why we invest and by increasing our savings via monthly, pre-authorized deposits, we can help increase our savings on an even larger scale.
Let’s see an example outlining the power of compounding interest by using a monthly pre-authorized withdrawal from your bank account, within an RRSP or a TFSA:
| Day 1 | After 10 years | After 20 years | After 30 years | After 40 years | |
|---|---|---|---|---|---|
| Deposits | $10,000 | $70,000 | $130,000 | $190,000 | $250,000 |
| Investment earnings | ─ | $23,470 | $99,435 | $260,907 | $561,662 |
| Balance | $10,000 | $93,470 | $229,435 | $450,907 | $811,662 |
(From Mawer Investment Management’s How Compound Investing Works, illustration as of April 27, 2020)
As you can see from the table above, by investing an initial $10,000 and adding $500 per month (that’s $6,000 per year) at a 5% rate of return, your investment has tripled within 40 years. Not too bad at all.
Now let’s add a little twist – try to increase your contributions by $20, $50, or $100 a month on an annual basis. Just like your cost of living increases by 1% to 2% every year, your savings should do the same because, let’s be honest, $1 dollar of goods today will not be worth $1 dollar of goods in a year.
Let’s see what this additional increase can look like. This chart illustrates the benefits of increasing your savings on an annual basis, partnered with the power of compounding interest; the results are impressive!
Growth of Savings Over 30 Years
| Returns | $20/Month | $50/Month | $100/Month |
|---|---|---|---|
| 7% | $260,737 | $651,841 | $1,303,683 |
| 6% | $228,119 | $570,298 | $1,140,596 |
| 5% | $200,394 | $500,986 | $1,001,972 |
Assumes you increase by $20/month, $50/month & $100/month once a year for 30 years and that you have enough TFSA contribution room for the above increases.
(From A Wealth of Common Sense, illustration as of November 13, 2020)
In the above scenario, the initial investment is $6,000 or a one-year max contribution into a TFSA. Based on the assumption that you are planning to raise your monthly pre-authorized deposit from $20 in year one, to $40 a month in year two, and so on, you can see that in 30 year’s time, you would save approximately $260,000 with a 7% rate of return. By increasing that annual monthly deposit to $100 per month, you can save as much as $1.3 million!
A mortgage, car payments, school tuition – we all have expenses and retirement can look different for each of us. Increasing your savings by $1,200 a year is a little high on the savings spectrum and may not be an option for everyone. However, $240 savings per year may be doable! The truth is that your retirement success is based on how much you save, so if you can start saving today, even a little each year, your savings will grow, giving you a few extra dollars to spend in your retirement and the peace of mind knowing you are secure.