The Effect of Compounding
Most people understand the importance of saving, but many discount the effect that compounding can have on their lives. Compound interest or returns can be beneficial to savers and harmful to spenders alike. As Albert Einstein said, compound interest is the “eighth wonder of the world.”
What is compound interest?
Simply put, compound interest is interest earning interest. For example, if a person deposited $10,000 in a savings account earning 2 per cent interest annually, the account would be worth $10,200 after one year. If the $10,200 were left alone for another year, the account would be worth $10,404. The extra $4 was earned on the $200 interest paid in the first year.
Interest that doesn’t compound is known as simple interest. If the above calculation was done using simple interest, the value at the end of 2 years would be $10,400. The account would earn the same $200 of interest per year whether the initial $200 of interest remained in the account or was withdrawn.
The power of compounding
Earning an extra $4 on a $10,000 investment is minimal, but the compounding effect becomes more significant as interest rates and account balances climb.
Consider a 30-year-old who invests $10,000 for 30 years at 5 per cent compounded annual interest. Ignoring other factors, the future value of the investment at the end of 30 years would be $25,000 using simple interest and $43,219.42 with compound interest. On the $10,000 deposit, that’s a difference of 182 per cent!
When to compound
There are several scenarios where compounding can make a positive impact on one’s financial future. Most long-term investments benefit from compounding. Those who invest in mutual funds and do not need to draw income from them should have any distributions reinvested into their fund rather than paid out in cash.
Similarly, those who buy dividend-paying stocks as long-term investments can potentially compound their returns by using a dividend reinvestment program (often called a DRIP) to acquire more shares on a regular basis. Both options have the potential to increase returns by using income paid by investments to acquire more of the investment.
Those who use high interest savings accounts with a floating interest rate such as those offered by Tangerine, will see their deposits compounded automatically.
Those buying bonds, GICs and other fixed income investments should use compounding carefully. For instance, compound interest is beneficial to savers in a falling interest rate environment because one might not be able to reinvest interest payments at a higher rate than the bond or GIC is receiving.
When to avoid compounding
Though its benefits are compelling, there are some situations where people should avoid compounding. The most notable is those who buy compound interest bonds or GICs with terms longer than 1 year in a rising interest rate environment.
For example, consider a 5-year GIC paying 4 per cent annually is purchased today. Each year for the next 5 years, interest rates rise by 0.50 per cent. The interest paid each year on a compounding GIC would have to remain in the GIC earning 4 per cent, while the non-compounding GIC would pay out the interest each year, which could then be reinvested at progressively higher rates.
Debt
Unfortunately, there are some cases where compounding can work against people, most notably on borrowed money. Just as compound interest can help one increase their savings, it has the opposite effect on debt. Debt is almost always compounded. In fact, interest charged on most mortgages in Canada is compounded semi-annually while credit card interest is compounded monthly or even daily!
Final thoughts
Compounding interest or returns can make a huge difference in one’s financial life, depending on how it’s used. With today’s low interest rates the effect of compounding can seem minimal in dollar terms, but it’s still an important component to wealth creation and preservation.