What is compounding interest?

How does compound interest work?

It’s simple: The interest, or earnings, you make on your assets are reinvested so you get additional earnings added back to your savings. A small investment can grow significantly by compounding over time. 

Compounding versus simple interest

Simple interest is a fixed percentage of the principal amount paid, usually every year. Bonds and guaranteed income certificates are investments that usually pay simple interest.

On the other hand, compound interest happens when the interest you receive is reinvested. It’s interest on the interest, which can mean growing your savings faster over time.

Do you need a special account for compounding interest? 

You don’t need a special account to take advantage of compounding interest. When you save in an RRSP or TFSA, your savings and interest can grow tax free and benefit from compounding.

Contributing to your group retirement plan on a regular basis is one of the best ways to take advantage of compounding. As your savings grow, the compound interest grows along with it. The earlier you start saving, and the more often you do it, the sooner you may reach your retirement goals. The longer the better. One-time contributions can also help boost the power of compounding.

Also, try not to take out or withdraw your money early from your plan—it can hurt the compounding effect, and higher fees can reduce your overall returns. Consider having all your plans in one place where you could benefit from the lower fees available in your group retirement plan and increase the compound interest effect.

How could you benefit from compounding interest?  

Let’s look at a couple of examples so you can get the full picture of the compound interest effect.

Example 1 Compound interest + Regular contributions 

You invest $250 a month into a retirement account with an annualized interest rate of 3%, compounded yearly. You’re now 65 years.

• If you started investing at 25, you could have $ 229,297 accumulated
• If you started investing at 35, you could have $ 144,678 accumulated
• If you started investing at 45, you could have $ 81,713 accumulated

Example 2 Compound interest with no additional contribution  

You have a smaller TFSA that you're transferring to your group plan. Let’s see how it adds up over the years.

Your scenario: $2,600 invested, no other contribution, with an annualized interest rate of 3%, compounded yearly.

• After 20 years, you could have $4,696 accumulated
• After 30 years, you could have $6,311 accumulated

Examples are for illustrative purposes only. 

5 helpful tips to maximize the compound interest effect 

Here’s how you can take advantage of the benefits of compound growth while you save for retirement:

1. Start early if you can—it’s never too late.
2. Contribute to your plan on a regular basis. 
3. Increase your regular contributions.
4. Put extra money, like a tax refund, into your plan if you can. 
5. Leave your money in your plan.

If you have questions, reach out to a financial advisor for help and more information on how you can achieve your financial goals faster.