FP summer school: Making compounding interest your friend

Melissa Leong | July 19, 2014 7:30 AM ET

Illustration by Mike Faille, National Post

Summer school isn’t punishment. Think of it as a second chance or bonus education. So whether you’re trying to repair your finances, make more cash or make smarter money decisions, we’re here to help. FP’s back to basics series continues with a lesson in compound interest.


It’s been called magical. A miracle. The eighth wonder of the world. You’d think it was a supernatural aura or a spectacular monument, but nope, it’s compounding interest.

Saving money can be hard. It involves discipline, sacrifice and planning. It involves putting aside today’s wants for future needs.

For motivation, think of the big picture, think about your goals, whether you’re saving for a home, education, retirement or a vacation. Continue reading

What exactly is that? Think of it as interest on interest. It’s interest on your initial principal and then on the accumulated interest. And think of its power like the Force. Depending on how it is used, the power can be good or evil. It can be your friend or your enemy depending on whether you earn it or you pay it.

How to make compounding interest your friend:

Time can turn compounding interest into your BFF. This friendship just grows and grows over the years and before you know it, it’s this huge, valuable asset that supports you.

“It’s like a snowball. You start with a little thing and it rolls down the hill and one day, you think, ‘Wow, I have a little nest-egg!’” says Kelley Keehn, author of A Canadian’s Guide to Money Smart Living. “We as Canadians, we hate to crunch numbers but numbers are our friends.”

Let’s say you invested $1,000 and it earned 5% in interest last year. Today, you’d be earning interest on $1,050.

Now, let’s say you left $1,000 in the bank to grow for 30 years with a 5% rate of return, compounded annually; even if you never added any more money, you’d have more than $4,300.

In other words, compounding interest can only be your best bud if you are patient.

“When you put something away compounding for a number of years, make sure you can stand that,” says Adrian Mastracci, a portfolio manager and president of KCM Wealth Management in Vancouver. “Or the chances of getting out of it with something in your pocket is not very good in terms of interest.”

Our low interest rates have dulled the potency of compounding interest with traditionally safe savings vehicles such as GICs and bonds. “Fourteen years ago, you got 5, 6, 7% on your GICs. You’d be excited to get 2% or 3% these days. On the plus side, inflation used to be higher so the net to you today is not bad.”

Whether you’ve invested your money in GICs, term deposits, mutual funds, stocks, bonds, exchange-traded funds, etc., where should you put your compounding interest? How about somewhere it can grow tax-free? “Because interest is taxed at the highest rate, that’s a good reason to put it in an RRSP or a TFSA or an RESP,” he says. “With a TFSA, you might be better with dividends and capital gains by buying stocks.”

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