The Magical World of Compound Interest

The magic of compound interest

Okay, so you have decided, that yes, this is the year you start investing

You’re pumped and ready to learn - and ready to get that money working for you.

But wait! The new Nintendo Switch just dropped last week. Oh, and spring is just around the corner, so you will need to sport a new outfit or two at work…And this winter has been extra miserable but a quick weekend trip to Vegas will rectify those winter blues.

It’s much more fun to spend money than to save and invest it. But while basking in that hot Vegas sun for the weekend may seem incredible at the time, you’re also giving up the most important power you have to grow your money:

The power of time.

The Compound Interest Power

Remember when we talked about how nice it would be to earn money without showing up and working for it? This is where the power of compound interest comes into play.

Simply put, it is the ability to earn interest on your interest.

(Pause and let the awe of that take over just for a moment...)

Now, let’s get into the nitty gritty.

How does it work?

Say you have $10,000 in a savings account that is currently paying 2% interest. At the end of the year, you will have $10,200. How did we get there?

$10,000 x 2% = $200

So you earned $200 in interest for the first year. (Big deal. You had to scrimp and save for that original $10,000!)

But what does the second year look like?

If you leave all the money in the savings account and resist withdrawing even a penny, then something magical happens:

$10,200 x 2% = $204

You end up earning $204 in interest in that second year!

It is compound interest at work: Extra money for doing absolutely nothing except NOT SPENDING IT.

Related: Money Lessons from 7 Books

Story of Kairi and Sora

Let’s take a look at the investing journey of these two best buds.

At the young age of 20, they chat about saving and investing and decide to make a bet:

Whoever has the bigger account when they hit age 65 wins!

For simplicity, let’s assume that they’ll invest in accounts that will not be subject to any taxes.

Related: Your Free Money - 14 Ways to Claim It Now

Kairi’s Journey

Kairi decides to jump in and save $5,000 right away when she is age 20.

She continues to add $5,000 every year for 15 years and then stops. She consistently earns 6% interest per year.

  • Age 20: $5,000
  • Age 21: $5,000 x 1.06 + $5,000 = $10,300
  • Age 22: $10,300 x 1.06 + $5,000 = $15,918

…. Lots more math and numbers for a couple more years…

  • Age 33: $94,411 x 1.06 + $5,000 = $105,075 (Already that’s a pretty awesome looking balance!)
  • Age 34: $105,075 x 1.06 + $5,000 = $116,380 (This is the 15th contribution that she has made)
  • Age 35: $116,380 x 1.06 = $123,363 (Only interest, no more contributions!)

… More numbers and more math and yes, I did set up an excel spreadsheet for this…

  • Age 64: $630,591 x 1.06 = $668,427
  • Age 65: $668,427 x 1.06 = $708,533

Holy crap! At the end of the year when Kairi turns 65, she will have a balance of $708,533.

To summarize:

Balance: $708,533

Contributions: $75,000

Interest: $633,533

Related: 10 Best Cash Back Credit Cards in Canada

Sora’s Journey

Sora had the best intentions of starting right away, but life got in the way.

You know how it is: new phone, new car, new clothes, new apartment, more clothes, more vacations… you get the idea.

He finishes his 20s off with a bang and then realizes that he has to buckle down if he wanted to have any chance of catching up to Kairi - and winning the bet.

So he also decides to contribute $5,000 a year and earns 6% interest per year as well.

  • Age 30: $5,000
  • Age 31: $5,000 x 1.06 + $5,000 = $10,300
  • Age 32: $10,300 x 1.06 + $5,000 = $15,918

…Looks familiar doesn’t it?...

  • Age 33: $15,918 x 1.06 + $5,000 = $21,873 (Ah man, Kairi’s at what already??)
  • Age 34: $21,873 x 1.06 + $5,000 = $28,185 (Ok perfect, she’s going to stop her contributions!)
  • Age 35: $28,185 x 1.06 + $5,000 = $34,877 (If I continue to contribute, I will win for sure!)

…Seriously who wants to look at this much math first thing in the morning? But bear with me…

  • Age 64: $520,919 x 1.06 + $5,000 = $557,174
  • Age 65: $557,174 x 1.06 + $5,000 = $590,604

At the end of the year when Sora turns 65, he will have a balance of $590,604.

To summarize:

Balance: $590,604

Contributions: $175,000

Interest: $415,604

The Clear Winner

Not only did Kairi contribute less than half of what Sora did over the years…

She still ended up with a higher balance as she had the money invested for a longer period of time than he did! BAM!

Mind blown.

Growing Your Army

Imagine every dollar that comes into your hands as workers…

When you spend those dollars, those workers no longer work for you. But if you save and invest those dollars, that is where the magic happens.

Those workers, with the right guidance, are going to generate more workers for you. And those workers will generate more workers and so on and so forth.

And before you know it, you will have amassed a whole army whose sole purpose is to make money for you while you sleep. Or eat. Or do whatever else you’d rather be doing!

As for the story of Kairi and Sora, naysayers will jump in and find numerous flaws:

  • they may argue about consistently earning 6% every year, or
  • being able to keep all those earnings away from the government who would want their share of it, or
  • even the daunting task of saving the $5,000 in the first place!

My response would be:

  • 6% may seem high but using 5% or 4% won’t change how time and compounding interest works.
  • In Canada, the government has provided us with these wonderful vehicles called Tax Free Savings Account (TFSA) that currently provide $5,500 of annual contribution room. (Never heard of it? No worries. I’ll go into more detail in another post.)
  • $5,000 a year is approximately $416 a month which breaks down to about $14 a day (if you have 30 days in the month). If $14 a day still seems like a lot, start with what you can and develop the habit of saving.

There is also tons of information on this website to help you find places to save money in all aspects of your life!

The biggest concern some may have is that you are hardly 20 anymore…

But instead of beating yourself up for it, the next best time to start is NOW.

Disclosure: Some links in this article may be affiliate links. We're letting you know because it's the right thing to do. Here’s a more detailed disclosure on how HTS makes money.

Hot Credit Card Deals This Month:

  • 30,000 welcome bonus points (worth $300), plus first year free
    • Earn 4 points for every $1 spent on gas, groceries, restaurants and entertainment
    • Earn 1 point for every $1 spent elsewhere
    • Points that can be redeemed for travel - anywhere, anytime, with no restrictions
    • 24/7 Concierge and access to Scotia Rewards Travel Service
    • Low $12,000 minimum income needed
    • Extensive insurance package
  • 25,000 Welcome Bonus Points (worth up to $781), Plus 2X Multiplier
    • Earn 1 point per dollar spent
    • Earn 2 points for every $1 spent at SPG and Marriott Rewards hotels
    • Transfer points to more than 30 airline rewards programs, usually 1:1
    • A free weekend hotel night when you spend $40,000 annually
    • Starwood gold status when you spend $30,000 annually
  • Earn 4 times the Cash Back for 4 Months
    • Earn 4% cash back for your first 4 months (up to $125)
    • Earn 1% cash back on all purchases after 4 months
    • Choose when you redeem your rewards
    • No limits on cash back earned
    • No annual fee
  • Not sure which credit card is for you? Take this short quiz and find out

Comments

Mrs. Picky Pincher's picture

Uhm, I REALLY enjoy the Kingdom Hearts reference. A fellow nerd salutes you, sir. :) But this is very true! Make sure you have time on your side to take advantage of compounding interest. That's basically the key to having enough funds during early retirement.

March 09, 2017 @ 9:11 am
Maria Weyman
Maria Weyman's picture

Love this post by Vicky - she's an actuary/mathematician so she knows her numbers... I'm saving this piece for my kids when they're about 8 or 9, because this is what kids should be learning at school. I missed the Kingdom Hearts reference though :(

March 10, 2017 @ 12:16 pm
Charlene
Charlene's picture

I want to know where I can get 6% GUARANTEED interest per year. Can't even find 2%.
Used to get 10+% (guaranteed) in the 80's and my money grew by far faster per year than it does now...
Freedom 55? more like 85...

March 09, 2017 @ 5:21 pm
Marpy
Marpy's picture

Negotiating sometimes works - I got 2% out of Tangerine for money in a high interest savings account for 90 days. In 90 days I will negotiate again. They also at times send out offers - the last offer I got was 3.25% for 90 days on any new money transferred.

March 12, 2017 @ 5:04 pm
Marpy
Marpy's picture

Hi Stephan- Yes compounding can work magic over time and the earlier you start the better off you are. As well, even though rates are low guaranteed investments give you the security of not losing any of your principle and interest earned. What inflation may or may not do to your nest egg may be a different story but regardless, IMO the saver always comes out ahead as that nest egg provides income that would otherwise not be available.
Another area where compounding and growth can work to ones favor is with blue chip dividend paying stocks. This is not guaranteed by any means, carries some risk, requires some work, steady monitoring and time. Good blue chip stocks grow their dividends over time and also pay out quarterly They also offer dividend reinvestment plans which when coupled with quarterly payout and growth in dividend can really bump up that compounding effect. Many blue chips (Canadian Banks for example) have a very good track record and pay 3 - 4% in dividends which have grown considerably over time.
Having said the above, although the rewards can be very high as compared to compounding in bank deposits , there is more risk involved as nothing is guaranteed in the stock market. Still for those who are interested and willing to put the time in, it could be a very worth while area to explore. As for Canadian bank shares, my personal feelings on them is that they are currently expensive and I am not a buyer at these prices.

Just My Opinion and as always your articles are always worth while and informative.

March 12, 2017 @ 4:14 pm
moneyhelp
moneyhelp's picture

"As for Canadian bank shares, my personal feelings on them is that they are currently expensive and I am not a buyer at these prices."

I agree, I would love to buy RBC shares, but at ~$100/share, its way too expensive. Hopefully, if they split their shares or if there is another market crash, you can bet that I would pick up some shares.

March 14, 2017 @ 3:17 pm