July 08, 2022

How does compound interest work?

By Madeleine Maltais

Did you know that compound interest can have a big impact on your personal finances? Compounding is what really helps your money grow. Here’s how. 

Have you heard about the “magic” of compound interest? Wondering how it works and what it can do for you? We can help you make sense of it all. 

What is compound interest?

Patience is a virtue! Compound interest is a case in point. In simple terms, the interest you earn on your investments is calculated at the end of each year. That amount gets added to your original investment the following year. You’ll then earn interest on your interest.

According to Jean-François Dufour, a Sun Life advisor, “being disciplined with your savings is more challenging at the beginning. The effects of compounding start slowly at first. But you’ll be convinced after you see a calculation.”

How does compound interest work?

Let’s use an example:

  • You start saving $100 per month when you’re 20.
  • This means you are saving $1,200 per year ($100 x 12 months).
  • If you keep saving $100 a month until you turn 60, you’ll have saved $48,000.
  • Thanks to compound interest, that $48,000 might be worth $200,000 instead!

“The magic of compound interest can quadruple your $48,000 to nearly $200,000. That kind of growth happens because your interest earns interest every year,” Dufour explains.

Want another example? Here’s another scenario:

  • You invest $1,000 in a Guaranteed Investment Certificate (GIC) for 5 years.
  • The financial institution offers an interest rate of 5% compounded annually. “Compounded annually” simply means that the interest is calculated once a year and is added to your original investment.
  • Your interest keeps earning interest year after year.

Let’s look at some numbers:

Year 1

Year 2

Year 3

$1,000 x 5% = $50

$1,050 x 5% = $52

$1,102 x 5% = $55

($1,000 + $50 = $1,050)

($1,050 + $52 = $1,102)

($1,102 + $55 = $1,157)

... and so on. After five years, your GIC will be worth $1,276!

This example shows the effects of annual compounding. Some investments offer monthly or even daily compounding. The more frequently the interest is calculated, the faster your investment will grow. In other words, with compounding, you earn interest on your interest!

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Can you ever be too old to benefit from compound interest?

The younger you start, the longer your money will keep compounding and the higher your savings will grow. But it’s never too late to develop some savings discipline. If you make saving automatic, you can save for the future without even thinking about it. 

How do you maximize compound interest?

Start saving as early as possible. For instance, make regular deposits to an RRSP or TFSA. With compound interest, your investment grows slowly at first and then accelerates over time.

What about interest rates?

Markets go up and markets go down. The better option is to be patient and stay the course. Higher returns in later years will make up for poorer returns.         

Worried about market volatility and the state of the economy?

It may be a good time to connect with your advisor. Here are 4 questions to ask.

Don’t have an advisor? Find an advisor today.

This article is meant to provide general information only. Sun Life Assurance Company of Canada does not provide legal, accounting, taxation, or other professional advice. Please seek advice from a qualified professional, including a thorough examination of your specific legal, accounting and tax situation.

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