(EN)
Compound Interest: How It Works and Why It's Amazing
Written by The Content Team | Published on March 8, 2019
MOST RECENT ARTICLES
Thank You!
You have been successfully subscribed to receive more Inspired Investor articles from RBC Direct Investing.
Your Subscription Failed
Your subscription to Inspired Investor has failed. Please try again at a later time.
It's been said that Albert Einstein once called compound interest the "most powerful force in the universe." Whether or not the wild-haired theoretical physicist was wowed by a savings strategy based on exponential math is debatable, but the value of compound interest is decidedly not.
What Is Compounding?
Compounding interest can be defined as "interest on interest." It means earning interest on your initial savings and then reinvesting it so you can earn interest on the new total – the original amount plus the interest. Simple interest, on the other hand, is interest paid on your initial savings only.
Here's a straight-forward example of compounding on a $100,000 investment that earns a guaranteed 2.5 per cent interest. (The example assumes annual compounding and no further additions to your savings.)
| Year | Value on January 1 | Interest earned (2.5%) | Value on December 31 |
| 1 | $100,000 | $2,500 | $102,500 |
| 2 | $102,500 | $2,562.50 | $105,062.50 |
| 3 | $105,062.50 | $2,626.56 | $107,689.06 |
| 10 | $124,886.30 | $3,122.16 | $128,008.45 |
| 25 | $180,872.59 | $4,521.81 | $185,394.41 |
As you can see, the longer your time horizon, the more significant the impact. It's a perfect example of how slow and steady wins the race. For comparison, the above example using a simple interest calculation would result in your investment growing to $162,500 over 25 years ($2,500 of interest paid each year on your principal amount without reinvesting). That falls short of the $185,394.41 after 25 years with compounding.
Of course, it's always important to think about the effects of inflation — the increase in the prices of goods and services over time — on investment returns, which can help you determine what investments are right for you. Over time, inflation reduces the purchasing power of your money.
While the above example is based on a guaranteed interest rate — something you may receive from a high-interest savings account, bond or Guaranteed Investment Certificate (GIC) — compounding can apply to other investments as well.
Compounding Investment Income
Individual stocks, mutual funds and exchange-traded funds (ETFs) can also pay income in the form of dividends1 and distributions, and compounding can come into play by reinvesting those earnings.
Here's how it works. If you own a dividend-paying stock, you receive regular dividend payments. You can choose to keep that income or reinvest it to buy more shares2. By reinvesting the dividend payouts, you increase the number of shares or units you own, thereby increasing your potential future dividend payouts. Think of it as earning "dividends on dividends."
Reinvesting distributions from mutual funds or ETFs that hold bonds or money-market securities can work in the same way. You can use the interest-income distributions you receive from a fund to buy more units, which would increase your future distributions because you'd own a higher number of units.
Remember, Compounding Also Works in Reverse
When your savings earn interest, you are on the receiving end of compound interest. But with personal debt like credit cards or car loans, it's possible to end up paying compounded interest. For example, if you carry a balance on your credit card, the interest you owe will compound each month. Assuming you don't make any payments, the interest owed on any balance you carry month-to-month would compound in the same way your savings did — steadily.
Finding the Space and Time
While it's unlikely that Albert Einstein spent much time thinking about compound interest what with that theory of relativity likely taking up so much time (and space!), investors can be well-served by understanding the "powerful force" of compounding.
View Legal Disclaimer
RBC Direct Investing Inc. and Royal Bank of Canada are separate corporate entities which are affiliated. RBC Direct Investing Inc. is a wholly owned subsidiary of Royal Bank of Canada and is a Member of the Investment Industry Regulatory Organization of Canada and the Canadian Investor Protection Fund. Royal Bank of Canada and certain of its issuers are related to RBC Direct Investing Inc. RBC Direct Investing Inc. does not provide investment advice or recommendations regarding the purchase or sale of any securities. Investors are responsible for their own investment decisions. RBC Direct Investing is a business name used by RBC Direct Investing Inc. ® / ™ Trademark(s) of Royal Bank of Canada. RBC and Royal Bank are registered trademarks of Royal Bank of Canada. Used under licence.
© Royal Bank of Canada 2023.
1 Dividends earned pursuant to DRIP may be subject to requirements imposed by the Income Tax Act (Canada). It is your responsibility to ensure that any associated tax requirements or obligations are satisfied.
2 The list of DRIP eligible securities is subject to change at any time without prior notice. RBC Direct Investing will purchase whole shares only. Some exclusions may apply. Some eligible securities such as preferred shares and voting class common shares will not reinvest into additional units of the same security but rather the underlying non-voting common share or similar security.
There may be commissions, trailing commissions, investment fund management fees and expenses associated with investment fund and exchange-traded fund (ETF) investments. On or after June 1, 2022, any trailing commissions paid to RBC Direct Investing Inc. will be rebated to clients pursuant to applicable regulatory exemptions. Before investing, please review the applicable fees, expenses and charges relating to the fund as disclosed in the prospectus, fund facts or ETF facts for the fund. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. For money market funds there can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you.
Any information, opinions or views provided in this document, including hyperlinks to the RBC Direct Investing Inc. website or the websites of its affiliates or third parties, are for your general information only, and are not intended to provide legal, investment, financial, accounting, tax or other professional advice. While information presented is believed to be factual and current, its accuracy is not guaranteed and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author(s) as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by RBC Direct Investing Inc. or its affiliates. You should consult with your advisor before taking any action based upon the information contained in this document.
Furthermore, the products, services and securities referred to in this publication are only available in Canada and other jurisdictions where they may be legally offered for sale. If you are not currently a resident of Canada, you should not access the information available on the RBC Direct Investing Inc. website.
EXPLORE MORE
Top 10 Traded Stocks and ETFs in February 2024
Here's what RBC Direct Investing clients traded and added to watchlists in February.
Be Strategic: 5 Things to Keep in Mind When Investing
From watching your emotions to the impacts of inflation to asset allocation, here are a few considerations when you invest.
Will I Get a Tax Slip for the New First Home Savings Account?
Find out where and when to expect your FHSA tax slip.
You Know More Than You Think
A guide to investing in stocks.