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Unlocking the Power of Compound Interest: Building Wealth for the Future Thumbnail

Unlocking the Power of Compound Interest: Building Wealth for the Future

Whether it’s the rising price of groceries and services, or the higher rates charged for mortgages, credit cards and other debt the reality is that financial challenges will always surface in everyday life. However, some factors being out of your control, there are certain deliberate actions you can take to improve your finances. For instance, consider investing regularly to help grow your wealth over the long term and take advantage of compound interest.

Understanding Compound Interest

With higher inflation comes higher interest rates to help cool off an overheated economy. That’s why it may cost you more these days to pay down your debt. On the flip side, savers have welcomed rising interest rates because, after decades of ultra-low rates (not too long ago, rates were sitting at or near zero), interest-bearing investments are finally providing some meaningful income.

So, if you hold GICs and/or a HISA at your financial institution, you can put a dent into soaring costs by earning more interest income. But it gets better. When you earn interest on such investments, you may reinvest the interest as it’s paid, which means your interest will actually start earning interest as well. In a nutshell, that’s the concept of compound interest.

Compound interest is when the interest you earn on a balance in a savings or investing account is reinvested, earning you more interest. The money you made on your principal investment is now making money of its own. Compound interest accelerates the growth of your savings and investments over time.

What does compound interest on debt mean?

Just like interest gets added to a principal investment and then compounds over time, interest gets added to your principal amount borrowed, and then the interest rate applies to the new (larger) principal on debts that are revolving i.e., credit cards and lines of credit. This is how debt can quickly get out of hand if it’s not managed. Unless you have a personal installment loan that has a fixed payment and end date, your interest is compounding if you are not keeping up with your payments.

Compound Interest In Action

Here’s a simplified example. Let’s say you invest $100,000 in a five-year GIC that pays 4% annually. Your principal amount will generate $4,000 of interest income after the first year ($100,000 x 4%). If you choose to reinvest the $4,000 in this GIC that’s yielding 4% per year – rather than take it as a cash payout – then that $4,000 will also earn 4% annualized interest. This means that for the second year of your GIC, you will receive $4,160 in interest ($100,000 original investment + $4,000 interest earned in year one x 4%).

For each year of your GIC, the accumulated interest you collect will continue to earn 4% annually on its own, in addition to your $100,000 original investment. The same principle applies to a HISA (high interest savings accounts), where interest is typically calculated daily and then that interest starts to generate its own interest income. There’s the magic of compound interest as an effective wealth builder over time. 

Investment flexibility

Here’s one more notable benefit of compound-interest savings vehicles like GICs and HISAs: you may hold them in registered plans or accounts – such as an RRSP, TFSA, RESP, RDSP and RRIF – that each have their own tax advantages, allowing you to retain more of your hard-earned money. Our job is to help you determine which account(s) to utilize.

Although the cost of living continues to rise, you can help keep pace by taking advantage of compound interest. It doesn’t even require you to invest a large lump sum. Some plans allow you to get started with as little as $50, and then you can add to your investment whenever the money is available. Consider a pre-authorized contribution (PAC) plan that automatically invests for you on a specific schedule (e.g., $100 per month). PACs can be a convenient way to invest regularly and allow compounding to build your long-term wealth.