Key Takeaways
- Most investment assets like stocks, ETFs, and mutual funds can provide compound interest and growth.
- Compound interest is when you earn interest on your interest, and this can benefit your investments but amplify your debts.
- Simple interest only calculates interest on your principal.
- The best way to benefit from compound interest is to start as early as possible.
Albert Einstein once said that “compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it.” In that one simple statement, Einstein summed up the greatest tool that any long-term investor can possess: time.
For most people, compound interest investments are the surest way to exponentially grow their wealth.
Think of your wealth as a snowball. When you are first starting out, you need to work hard to shape it and form the foundation. But as the snowball rolls, it picks up more snow and grows larger and larger.
Right now, it might seem like your investments are just a snowball, but with the help of compound interest, at retirement, it could be an avalanche.
There is a reason why they say time in the market beats trying to time the market. Investing early and letting time and compound interest do the heavy lifting is the simplest way to grow your wealth.
This article will explain everything you need to know about compound interest investments in Canada for 2024.
Table of Contents Show
What is Compound Interest, and How Does It Work?
The analogy we used with the snowball is easy to visualize, but to better illustrate compound interest, let’s crunch some real numbers. The simplest way to think about compound interest is with an investment’s CAGR or Compound Annual Growth Rate.
For example, let’s take the benchmark returns of the S&P 500 index. Since its inception in 1957, the S&P 500 has returned roughly 10% per year to investors. This includes capital growth and dividend reinvestment. Let’s take a look at what an initial investment of $10,000 in the S&P 500 looks like over time.
| Year 1 | $10,000 |
| Year 2 | $11,000 |
| Year 3 | $12,100 |
| Year 4 | $13,310 |
| Year 5 | $14,641 |
| Year 6 | $16,105.10 |
| Year 7 | $17,715.61 |
| Year 8 | $19,487.17 |
| Year 9 | $21,435.89 |
| Year 10 | $23,579.48 |
| Year 11 | $25,937.42 |
| Year 12 | $28,531.17 |
| Year 13 | $31,384.28 |
| Year 14 | $34,522.71 |
| Year 15 | $37,974.98 |
| Year 16 | $41,772.48 |
This is a growth of $10,000 over a period of 15 years at a 10% growth rate. Keep in mind that this is without adding a single penny since your initial contribution. You can imagine how much more this would grow if you continued to contribute, say, $10,000 each year.
After a quick calculation, if you added a further $10,000 each year, your total at the end of 15 years would be a staggering $359,370.21. This is the power of compound interest.
How can you calculate the growth of compound interest investments? There is a mathematical formula that looks like this:
Total Amount = P [(1+I)n -1]
P = the principal or initial investment
I = Annual interest rate
n = Number of compounding periods
Let’s use our example from the table above:
Total Amount = 10,000 [(1+0.10)15 -1] = $41,772.48
Another way you can calculate this is to keep multiplying your principal by 1.10. If you do this 15 times, you also get to the number of $41,772.48.
Best Compound Interest Investments in Canada
Individual Stocks
Individual stocks are one of the best ways to earn compound interest in Canada. Although stocks do not come with an annual interest rate or set returns each year, over time, holding these stocks can create its own compound interest.
As companies perform well and the price of the stock rises, you will begin to realize capital growth with each passing year. Over time, you can divide your total returns by the number of years you have owned the stock to calculate your compound annual growth rate.
Another way to take advantage of compound interest with stocks is to reinvest your dividends. This is akin to earning interest and re-investing that interest into your original principal.
Dividend Reinvestment Plans, or DRIPs, are one of the best ways to compound your growth in individual stocks over the long term.
We should mention that stocks are one of the riskiest compound interest investments. There is a very real potential for unlimited losses. Remember, not every stock goes up over time, so you will need to pick the right ones to reap the benefits of compound growth.
Equity and Bond ETFs
ETFs or Exchange-Traded Funds are baskets of assets that trade on stock exchanges like the TSX. These can hold assets like stocks, bonds, other ETFs, or a mix of all three.
The idea with ETFs is that investors can gain exposure to multiple assets or asset classes, with lower volatility. ETFs are generally safer investments than stocks but do not have as much potential upside for future gains.
You can definitely still benefit from compound interest with ETFs. Like with stocks, ETFs still provide capital growth as well as the ability to reinvest any dividends that are earned.
When it comes to bond ETFs, these funds will pay out monthly or quarterly distributions of interest. This can be re-invested into the same ETF to buy more shares and grow your position over time.
Mutual Funds
Mutual funds are similar to ETFs: both are pools of investor money that are invested into a basket of assets like stocks. The main difference is that ETFs trade on stock exchanges while mutual funds are offered by financial institutions like banks.
Mutual funds can also provide compound growth as the assets that are held rise in value. There is also the ability to re-invest dividends to compound the growth of your initial investment. Mutual funds have a similar risk profile to ETFs and are best for passive, long-term investors.
Guaranteed Investment Certificates (GICs)
GICs have been popular investments this year as Canadian interest rates continue to rise as the Bank of Canada battles inflation in the economy.
These assets are similar to loans and pay a guaranteed interest rate on your initial investment. This interest is often compounded annually and paid out at the maturity of the GIC. This means that after each year that you hold your GIC, the interest is added to your original principal. The next year’s interest will be calculated on the new, higher principal, thus starting the process of compound growth.
GICs are one of the safest compound interest investments in Canada and are directly impacted by the Bank of Canada’s overnight interest rate.
High-Interest Savings Accounts (HISAs)
Like GICs, HISAs have been popular this year as Canadian interest rates continue to rise. The higher the rates, the higher the HISA is able to pay out on your account balance. Interest on these accounts is usually compounded daily and paid out monthly.
As long as you leave your money in the account, it will continue to accrue interest and pay out more each month.
This is the safest form of compound interest investing in Canada as it is simply a bank account with a higher interest rate.
Real Estate Investment Trusts (REITs)
REITs are popular assets among dividend and income investors. Why? Because REITs typically pay out a high yield on a monthly or quarterly basis. REITs trade on stock exchanges and represent a company that owns and manages physical real estate assets.
By law, 90% of the REIT company’s taxable income must be paid out to shareholders through a dividend. In exchange for this high threshold, REITs are not subject to any corporate taxes.
Generally, REITs do not provide much capital growth but do provide generous dividends which can be re-invested. REITs can be risky but are generally low-volatility assets with a high yield.
Real Estate Assets
You might not think of real estate when it comes to compound interest investments, but these assets can certainly provide compound growth. Investing in real estate does take a large amount of money and some work.
To initiate compound growth in real estate, you need to own at least two properties. As cash flow increases from collecting rent, so too does your equity. The more properties you own, the higher the cash flow, and this is how compound growth kicks in.
Obviously, investing in real estate can be risky, especially leveraging one property to buy another. Finally, you are also assuming that property values rise over the long term and outpace your cash flow each month.
Alternative Assets
Alternative assets can be anything from artwork to sports memorabilia. These can be tricky assets to value as most prices are determined by supply and demand. The idea of compound growth in art depends on how long you hold these pieces for.
Similar to stocks, you can calculate the value each year by getting your art appraised. If this value continues to rise, you are seeing the results of compound growth as a result of a fixed supply and rising demand.
Alternative assets like art tend to have a high barrier to entry and can be an expensive asset class to invest in.
Cryptocurrencies
Last but not least is the riskiest asset class of them all: cryptocurrencies. Even cryptos can be compound interest investments, as there are plenty of ways to earn interest on your crypto.
One such way is called staking. This involves pledging your cryptocurrencies to help validate the network and improve protocol security. The easy way to look at this is you provide your crypto to a staking service, and you get paid back interest. This can be re-invested continuously to help grow your initial staking investment.
Note that you will need to sign up with a crypto exchange that offers staking services to earn compound growth on your crypto assets. Cryptocurrencies are also extremely risky so please do your research before considering them as a long-term investment.
Best Investment Accounts for Compounding Interest Investments
When it comes to compound investing, the key ingredient is time and a long-term investing horizon. This is why we say: the younger you can start investing, the more your money can grow.
Savvy Canadian investors will know all about maximizing contributions to tax-friendly accounts like the TFSA or RRSP. The TFSA or Tax-Free Savings Account will allow your investments to grow tax-free for the rest of your life. Any interest, dividends, or capital gains earned are completely tax-free.
An RRSP or Registered Retirement Savings Plan is just as good as a TFSA. Any contributions made to your RRSP are tax-deductible, which means they are taken off of your taxable income for the year.
Unlike the TFSA, you will eventually be taxed on RRSP withdrawals, but ideally, this will be at a much lower marginal tax rate in retirement.
Related: GICs vs TFSA.
What is the Rule of 72? How To Take Advantage of Compound Interest
The rule of 72 is a finance equation that you can use to calculate approximately how many years it will take for your money to double with a specific rate of return. It is commonly used to calculate the long-term effects of compound interest on investments. Here is the calculation used for the Rule of 72:
Years to Double = 72/Expected Rate of Return
If you have a rate of return of 6.0%, the number of years to double the principal will be 72/6 or 12 years.
Remember that the Rule of 72 is an approximation and only takes into account a steady expected rate of return.
Compound Interest vs Simple Interest
The primary difference between simple and compound interest is that simple interest is only calculated on the principal. Compound interest is calculated on the principal plus any interest earned, so you are earning interest on interest.
The simple formula to calculate simple interest is as follows:
Principal x Interest Rate x Term
For example, how much is the simple interest on a $5,000 loan at a rate of 5.0% for 5 years?
$5,000 x 0.05 x 5 = $1,250
Over the span of 5 years, you can expect to pay simple interest of $1,250 or $250 per year.
Which is better? That usually depends on whether you are earning interest or paying back interest on a loan. When you are earning interest you always want it to be compound interest because it will grow your principal faster. If you are paying back a loan, then you would obviously prefer it to be a simple interest loan.
Pros and Cons of Compound Interest
The obvious benefit of compound interest is it grows your wealth at a much faster rate than simple interest. Earning interest on interest is the great secret to building wealth over time.
If you start the compound interest process early, it can yield incredible returns in the future. The earlier you start, the more your money will grow in the long run.
There is a very ugly and negative side to compound interest as well. Compound interest can amplify your debt, and we see this in the case of credit card debt. This interest can be compounded daily and unless you pay the balance off, the interest will continue to accumulate.
One other drawback is that you do need time for compound interest to work effectively. Unless you have a long investing horizon, you might not see the true impact that compound interest has
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Editorial Disclaimer: The investing information provided here is for informational purposes only and is not intended as individual investment advice or recommendation to invest in any specific security or investment product. Investors should always conduct their own independent research before making investment decisions or executing investment strategies. Savvy New Canadians does not offer advisory or brokerage services. Note that past investment performance does not guarantee future returns.
Compound interest is a powerful tool for long-term investors that allows them to earn interest on their interest, leading to exponential growth of their investments over time. It is important to understand the concept of compound interest and how it works in order to make informed investment decisions.
What is Compound Interest, and How Does It Work?
Compound interest is the process of earning interest on both the initial principal and any accumulated interest. This means that as your investment grows, the interest earned also increases, leading to a compounding effect. Albert Einstein famously referred to compound interest as the eighth wonder of the world, emphasizing its potential for wealth accumulation over time.
To better illustrate compound interest, let's consider an example using the benchmark returns of the S&P 500 index. Since its inception in 1957, the S&P 500 has returned an average of approximately 10% per year to investors, including capital growth and dividend reinvestment. Suppose you make an initial investment of $10,000 in the S&P 500. Over time, the investment would grow as follows:
- Year 1: $10,000
- Year 2: $11,000
- Year 3: $12,100
- Year 4: $13,310
- Year 5: $14,641
- Year 6: $16,105.10
- Year 7: $17,715.61
- Year 8: $19,487.17
- Year 9: $21,435.89
- Year 10: $23,579.48
- Year 11: $25,937.42
- Year 12: $28,531.17
- Year 13: $31,384.28
- Year 14: $34,522.71
- Year 15: $37,974.98
- Year 16: $41,772.48 [[1]]
As you can see from the example, the initial investment of $10,000 grew to $41,772.48 over a period of 15 years at a 10% growth rate. This growth occurred without adding any additional contributions. If you continued to contribute $10,000 each year, the total at the end of 15 years would be a staggering $359,370.21 [[1]].
The growth of compound interest investments can be calculated using a mathematical formula:
Total Amount = P [(1+I)^n - 1]
Where:
- P is the principal or initial investment
- I is the annual interest rate
- n is the number of compounding periods
Using the example from above, the total amount can be calculated as:
Total Amount = $10,000 [(1+0.10)^15 - 1] = $41,772.48
Alternatively, you can calculate the growth by multiplying the principal by the interest rate plus 1 for each compounding period. In this case, multiplying $10,000 by 1.10 for 15 times also yields $41,772.48 [[1]].
Best Compound Interest Investments in Canada
In Canada, there are several investment options that can provide compound interest:
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Individual Stocks: Investing in individual stocks can generate compound interest over time. As the stock price rises and companies perform well, you can realize capital growth. Dividends received from stocks can also be reinvested, similar to earning interest on interest.
-
Equity and Bond ETFs: Exchange-Traded Funds (ETFs) are baskets of assets that trade on stock exchanges. ETFs can hold stocks, bonds, or a mix of both. Like individual stocks, ETFs can provide capital growth and the ability to reinvest dividends.
-
Mutual Funds: Mutual funds are similar to ETFs in that they pool investor money and invest in a basket of assets. They can also provide compound growth as the assets held by the fund increase in value. Dividends received from mutual funds can be reinvested to compound the growth of the initial investment.
-
Guaranteed Investment Certificates (GICs): GICs pay a guaranteed interest rate on the initial investment and often compound the interest annually. They are considered one of the safest compound interest investments in Canada.
-
High-Interest Savings Accounts (HISAs): HISAs are bank accounts that offer higher interest rates. The interest on these accounts is usually compounded daily and paid out monthly, allowing for the growth of the initial investment over time.
-
Real Estate Investment Trusts (REITs): REITs are companies that own and manage real estate assets. They typically pay out high dividends on a monthly or quarterly basis. While they may not provide significant capital growth, they offer the potential for compound growth through dividend reinvestment.
-
Real Estate Assets: Investing in real estate can also provide compound growth. As cash flow increases from rental income, equity in the properties grows, leading to compound growth. However, investing in real estate requires a significant amount of money and carries risks.
-
Alternative Assets: Alternative assets such as artwork or sports memorabilia can also provide compound growth. The value of these assets can appreciate over time, leading to compound growth if held for an extended period.
-
Cryptocurrencies: Cryptocurrencies can be considered compound interest investments through various methods, such as staking. Staking involves pledging cryptocurrencies to validate the network and earn interest on the investment.
It's important to note that different investment options come with varying levels of risk and potential returns. Investors should conduct their own research and consider their risk tolerance before making investment decisions.
Best Investment Accounts for Compounding Interest Investments
When it comes to compound investing, time and a long-term investing horizon are crucial. Starting to invest early allows for more significant growth potential. In Canada, two popular investment accounts for compounding interest are the Tax-Free Savings Account (TFSA) and the Registered Retirement Savings Plan (RRSP).
The TFSA allows investments to grow tax-free, meaning any interest, dividends, or capital gains earned are not subject to taxation. Contributions to a TFSA are made with after-tax dollars, and withdrawals can be made tax-free at any time.
The RRSP, on the other hand, allows for tax-deductible contributions. Contributions made to an RRSP are deducted from taxable income, reducing the tax burden in the year of contribution. However, withdrawals from an RRSP are subject to taxation, typically at a lower marginal tax rate during retirement.
Both the TFSA and RRSP offer advantages for compound interest investments, and savvy Canadian investors often maximize contributions to these accounts.
The Rule of 72: How To Take Advantage of Compound Interest
The Rule of 72 is a finance equation that provides an approximation of how many years it will take for an investment to double at a specific rate of return. It is commonly used to calculate the long-term effects of compound interest.
The calculation for the Rule of 72 is as follows:
Years to Double = 72 / Expected Rate of Return
For example, if you have a rate of return of 6.0%, it would take approximately 12 years for your investment to double (72 / 6 = 12).
It's important to note that the Rule of 72 is an approximation and assumes a steady expected rate of return.
Compound Interest vs Simple Interest
The primary difference between compound interest and simple interest lies in how the interest is calculated. Simple interest is calculated only on the principal amount, while compound interest takes into account both the principal and any accumulated interest.
The formula for calculating simple interest is:
Principal x Interest Rate x Term
For example, if you have a $5,000 loan with a 5.0% interest rate for 5 years, the simple interest would be:
$5,000 x 0.05 x 5 = $1,250
In this case, you would pay $1,250 in simple interest over the span of 5 years, or $250 per year.
Compound interest is generally preferred when earning interest because it allows for faster growth of the principal. However, when paying back a loan, simple interest may be preferred to minimize the overall interest paid.
Pros and Cons of Compound Interest
Compound interest offers several benefits for investors, including:
- Exponential growth of wealth over time: Earning interest on interest allows for significant wealth accumulation in the long run.
- Potential for incredible returns: Starting the compound interest process early can yield impressive results.
- Safest form of compound interest investing: High-Interest Savings Accounts (HISAs) and Guaranteed Investment Certificates (GICs) are considered safe investment options.
However, there are also drawbacks to compound interest:
- Amplification of debt: Compound interest can amplify debts, as seen with credit card debt. If the balance is not paid off, the interest continues to accumulate.
- Time requirement: Compound interest requires time to work effectively. The longer the investing horizon, the greater the impact of compound interest.
- Risk associated with certain investments: Some compound interest investments, such as individual stocks and cryptocurrencies, carry higher levels of risk.
It's important to carefully consider the pros and cons of compound interest and choose investment options that align with your financial goals and risk tolerance.
Please note that the information provided here is for informational purposes only and should not be considered individual investment advice. It's always recommended to conduct your own research and consult with a financial advisor before making investment decisions.
