The power of compound Interest and compounding growth

A simple definition of compound interest is “earning interest on interest”.  This means that as you make contributions towards the principal of your investment, the interest earned is then added to the existing principal and the combined amount could then earn even more interest.

To help you understand, considering all things being equal, let’s imagine you contribute $10,000 to a hypothetical investment that earns six percent annually. Six percent earned on your first-year contribution calculates to $600, making your balance $10,600. Now, when you make your second-year contribution of an additional $10,000, the principal will now include both the invested portion ($20,000) AND the interest earned ($600), and the six percent interest earned in year two will be calculated from this total amount.

Let’s calculate the math of the first two years of investments and interest earned:

$10,600 (Starting amount - Your principal and interest from Year 1)

+  $10,000 (your Year 2 principal contribution investment)

$20,600 (Year 1 total + Year 2 principal – now a lump sum of principal)

+  $1236 (6% of $20,600, your Year 2 interest)

$21,836 (your new total balance)

You may find you’re not earning a lot of interest early in your savings journey, but with compound interest, time is always on your side. As the interest earned grows and is reinvested, the compound interest earned can grow to a point where it may be the largest factor contributing to the growth of your investment!

Compound interest investments can be bank-type or money market assets that grow in value and earn money through capital gains or interest. The key to compound interest is when the money earned through interest is reinvested into the asset to generate larger long-term payouts.

Rather than simply creating growth by continually adding to your savings, compound interest investments will aggregate principal amounts with previously earned interest to create a larger nest egg from which even more interest can be earned.  Long term investments are considered one of the best ways to benefit from compound interest, but even short-term investments can see more growth from compound interest than other options.

Compound interest is calculated by multiplying the initial sum of money, or principal, by one plus the annual interest rate raised to the number of compound periods minus one. This will leave you with the total amount including compound interest that you would have earned.

Formula for Calculating Compound Interest

The compound interest formula is:

A = P(1+r/n)^nt

Where: 

P is the principal (the starting amount)

r is the annual interest rate, which is written as a decimal

n is the number of times the interest compounds each year

t is the time, or total number of years

A is the total amount you will wind up with at the end of the timeframe.

When calculating compound interest, you first want to know the funding amount you plan to start with (P), and the timeframe for which you will invest (t). 

From there, consider two variables when deciding what works best for your plans:

the interest rate (r) - larger interest rate means more interest will be added to each cycle compounding frequency (n) - the more often the interest compounds, the faster the growth of your investment. 

The chart below provides an example of the difference between how a $1000 invested at 10% looks when compounded monthly and annually (for information purposes only):

Here are some of the options you might consider as an investor: 

1. Certificates of deposit (CDs) are available through banks and other financial institutions. When you are buying into a CD, you’re lending money to a bank or financial institution for a predetermined amount of time - usually six months to five years. In return, the bank agrees to pay you interest over this term, so the longer the term will generally mean a larger interest rate. At the end of the term, you’ll receive your original investment plus any interest earned. Guaranteed Investment Certificate (GICs) are the Canadian equivalent of CDs. Though CDs or GICs might not earn as high interest rates as other options on this list, they are considered mostly low risk options to grow your investments and capitalize on the benefits of compound interest.
2. High-yield savings accounts offer higher interest rates than traditional savings accounts and slightly lower interest rates than CDs, but they don’t come with the term commitments that CDs do. This means that you have greater access to your money when you want it, with the tradeoff being that you might not earn as much interest. Returns on high-yield savings accounts can also fluctuate depending on the market, and some might require a minimum balance or a fee to access the accounts.
3. Bonds and bond funds are generally issued by government agencies or corporations when they are looking to raise money. This means that you are an investor buying a bond and are essentially providing a loan to the agency. This loan will typically have an end date, at which point the bond will mature and you will be paid back the face value of the loan along with interest earned. Bonds can be great options if you’re looking for long term investment opportunities, however the amount of returns or interest earned can be impacted by the rising and falling of the price of the bond over its lifetime. Corporate-issued bonds can provide higher interest rates of returns than government bonds rates but could hold more risk, depending on various financial considerations. Government bonds are seen as some of the safer investment options available as they are backed by the various levels of government.
4. Money market accounts are interest-bearing accounts similar to regular and high-yield savings accounts. The benefit to money market accounts is that some allow for cheque writing or debit card features, which means greater access to your money. Similar to high-yield savings accounts, there could be a minimum balance required in the account so always ensure you understand your responsibilities to avoid any fees!
5. Dividend stocks essentially involve you buying a piece of a company, so when that asset increases in value so does your investment. The stock market and the company you have invested in continues to perform well, your stocks can provide regular cash flow in the form of dividends, which you can reinvest (Dividend Reinvestment Plan or DRIP) and fully realize the power of compound growth or use for regular cash flow purposes. With the potential for added reward comes additional risk, and there is no guarantee that a stock will increase in price. Economic uncertainty can play a part in the ability to compound growth with these types of investments, but the payoff may net you greater returns as well.
6. Mutual Funds are different from purchasing individual stocks. These funds are investments in multiple stocks, bonds and other securities and combine money from multiple investors. Mutual Funds offer returns to their investors in multiple ways, which include dividend payments on the securities that make up the fund holdings and income in form of distributions. This can either be collected in cash or reinvested for compounded growth.
7. Exchange-Traded Funds (ETFs) are investments that track or follow the increases and decreases of various indexes such as the S&P 500 or Toronto Stock Exchange; various sectors of the economy like tech or health; or different geographic regions such as North America or Europe.

You’re able to buy and sell ETFs from the stock market directly through brokerages, usually without any fees attached.  Many investors appreciate the flexibility of ETFs and the ability to diversify their investments without the need to buy many individual stocks. Though ETFs do not generate compound interest, they are traded on stock exchange and there are chances for the fund to appreciate in value, thereby, offering an opportunity to generate compounded growth.

Real estate investment trusts (REITs), are companies that provide the option to invest in real estate through their organization without having to directly purchase real estate yourself. Modeled after mutual funds, REITs pool resources from multiple investors and use this money to invest in all types of real estate. REITs pay out dividends each year and investors may reinvest these payouts to experience compound growth over the years. Although these investments are beneficial if you are looking to diversify your portfolio and invest in the real estate sector, they are subject to the fluctuating value of the real estate sector, which could impact your returns.

As with any investment, lower risk will typically net you lower returns, and higher risks may  potentially net you higher returns. Options like high-yield savings accounts, money market accounts and certificates of deposits may net you lower interest rates than some options, but may still offer opportunities for year-over-year growth.  Equity stocks and to a lesser extent REITs, Mutual funds and ETFs could incur higher risks, but the potential for higher returns is a factor to consider.

When thinking about ways to help you benefit from compound growth, think of a snowball rolling down a path: 

1. Start Early - The earlier on the path you can start rolling your snowball, the longer it will have to accumulate growth by the end of its run. The longer you can invest your money, the more chance it will have for compounding growth.
2. Make Regular Contributions - If you’re able to add more to the snowball at the beginning of the journey, or even throughout its path, the better chance you’ll have of a bigger snowball when all is said and done. Consistent contributions to your investments can provide a huge boost in setting yourself up for long-term growth. Even if you can’t contribute much to begin with, consistency of any amount is still better than sporadic or no contributions. Keeping in mind that life is always changing, contribute what you can to begin with to establish consistency, and reevaluate later to see if you can increase contributions. 
3. Stay “Invested” in the market - Your snowball will experience the biggest growth if you just continue to let it roll. If you were to stop and move it around, you could potentially be losing out on the opportunity to let it grow, or even worse, making it start from scratch. With investing, time is on your side. It's important that you make your money continue to work for you by keeping it invested and not withdrawing it, to generate compounded growth, or at least to beat inflation. Moreover, you may want to review your investments to ensure they are growing (technically ensuring your snowball is still rolling forward).    
4. Diversify your investments - If you can spread out multiple snowballs to different paths, you can help your overall accumulation at the end of your path, particularly if some paths have disruptions along the way. If you can diversify your money over multiple investment options, this will also help you weather any fluctuation that arises during times of uncertainty in various markets. However, it's imperative to track the performance of your portfolio and make adjustments along the way to ensure your investments continue to grow and yield compounded growth.

Keeping these factors in mind can help your snowball, or your investments, get where you want them to be. 

Is Compound Interest a good investment?

Compound interest isn’t really a type of investment, but rather a feature of certain investments or financial instruments. The benefit of compound interest and ongoing contribution can help you achieve your investment goals. 

Start saving early to get a head start on compounded growth?

Successful savings is also about timing and amount. So, starting to save early and contributing regularly to your investments will give you the best chance at growth. The higher the amount of savings you can afford early on will help to have a positive impact later. 

Is money safe in compound investments?

There are many different investment vehicles that you can invest in to experience compound growth, each with their own risk levels and corresponding returns. Typically, the higher the risk, the greater the potential return, and the lower the risk, the less interest to earn. It’s important to choose what’s right for you, understanding what will help you reach your financial goals and when. 

 Which investments grow money faster?

Buying stocks and equities historically have reaped the largest returns over time, but this also comes with a certain amount of volatility. Investors need to determine their own timelines and goals and make decisions based on what works best for them. 

You work hard for your money, so why not make your money work as hard as you? Utilizing all the tools relevant to you can help ensure your investments are working towards your goals. Combining applicable research, tools and resources can help to make well-informed decisions to help you achieve your financial goals.