How Compound Interest Works, and Why Starting Early Matters
Compound interest means earning interest on your interest. It sounds like a small detail, but over decades it can produce more of your final balance than the money you put in. It also works in reverse when you owe money, so it is worth understanding either way.
Simple and compound interest
With simple interest, $10,000 at 5% earns $500 every year, so after 20 years you have $20,000. With interest compounded yearly, each year's interest is added to the balance and earns interest itself. After 20 years you have about $26,533, and after 30 years about $43,219.
Why time matters so much
Growth speeds up the longer it runs. Suppose you save $200 a month at 5%, compounded monthly. After 20 years you have put in $48,000 and the balance is about $82,207. After 30 years you have put in $72,000 and the balance is about $166,452. Ten more years of saving adds $24,000 of your own money but about $84,245 to the balance. Starting earlier often matters more than contributing more later.
A quick estimate: the rule of 72
Divide 72 by a yearly return to estimate how many years money takes to double. At 6% that is about 12 years, and at 3% about 24 years. It is an approximation, but a handy way to compare rates in your head.
What reduces the result
- Fees. A yearly fee of 1% or 2% comes out every year and compounds against you, so compare costs when you choose an investment.
- Tax. Interest in a taxable account is usually taxed. In registered accounts such as a TFSA or RRSP, growth is sheltered, though the rules differ. Check the current rules and your contribution room with the Canada Revenue Agency.
- Inflation. A dollar in 20 years buys less than a dollar today, so look at the result in today's money as well.
- Uneven returns. Savings rates change and investments rise and fall. Try a low, a middle and a high rate to see a range rather than one promise. Investments with higher expected returns can also lose value.
The same maths works against you on debt
A credit card at 20% compounds much faster than most savings grow. If you carry a balance, paying it off is often the best return available to you, and it is guaranteed.
How often interest compounds
More frequent compounding pays slightly more at the same quoted rate, but the difference between monthly and daily is small. The rate, the time and how regularly you contribute matter far more.
Try it: Try your own amounts with the free compound interest calculator, or work backwards from a target with the savings goal calculator.
This guide is general information for everyday budgeting, not financial, tax or legal advice. Rules, limits and rates change, so check official sources or ask a qualified professional about your own situation.
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