# Wise Up on Compound Interest: A Powerful Force for Savings

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“The most powerful force in the universe.” “The greatest invention in the history of mankind.”

Many people claim that Albert Einstein said these words about compound interest. Whether he did it or not, one thing rings true.

When considering a wealth building strategy, compound interest is a very powerful savings tool. Read on to learn all about the composition and the best way to reap the rewards.

## What is compound interest?

Compound interest builds your money at an accelerated rate. It’s interest on top of interest: your deposits earn interest, and interest also earns interest.

This can lead to incredible growth over time.

In contrast, simple interest is equivalent to interest on the original principal from year to year. Previous interests are not taken into account.

Let’s say – hypothetically – that you put \$ 20,000 into a high interest savings account that compounds interest at 2.80%. If the account stayed at this rate for five years, your savings would increase like this:

Interest compounded over 5 years at 2.80%
Year Initial balance Interest earned Final sale
1 \$ 20,000 \$ 560 \$ 20,560
2 \$ 20,650 \$ 576 \$ 21,136
3 \$ 21,136 \$ 591 \$ 21,727
4 \$ 21,727 \$ 609 \$ 22,336
5 \$ 22,336 \$ 625 \$ 22,961

Now let’s see what a simple interest at the same rate, over the same period, would look like for comparison.

Simple interest over 5 years at 2.80%
Year Initial balance Interest earned Final sale
1 \$ 20,000 \$ 560 \$ 20,560
2 \$ 20,560 \$ 560 \$ 21,120
3 \$ 21,120 \$ 560 \$ 21,680
4 \$ 21,680 \$ 560 \$ 22,240
5 \$ 22,240 \$ 560 \$ 22,800

The difference between the \$ 22,961 with compound interest does not appear to be much more than \$ 22,800 with simple interest. But flash forward at the end of 23 years in this scenario.

With compound interest, you’ll get almost double your initial investment for \$ 37,746, whereas with simple interest you just watch \$ 32,880. By the end of the 50th year, compound interest will have accrued \$ 79,558, versus \$ 48,000 at simple interest over the same period.

Now imagine the power of compound interest if you contribute regularly to that savings account.

## Compound interest and savings

Here’s the good news: Compound interest is far more common than simple interest when it comes to savings. There are several types of savings vehicles you can open to make compound interest work for you.

Guaranteed Investment Certificates (GICs) are probably one of the safest places to keep your money and see it grow. GICs offer guaranteed high interest rates, but lock in your funds for a fixed term.

These terms vary from 90 days to five years or more, and there are penalties for early withdrawal.

When the term ends, you have the option of renewing and growing your money in the GIC or withdrawing it. All previous accumulations will be carried over to the next fixed term.

The locked-in nature of GICs can be restrictive, especially if you’re planning on opening an emergency savings account that you’ll need quick access to.

You will also not be able to deposit any other funds into the GIC until it matures and is renewed.

High yield savings accounts will give you the flexibility to withdraw and deposit funds whenever you want, and the accounts offer solid returns over time.

To keep your short-term savings more nimble, a high yield savings account might work better.

## Be like Buffett

When you talk about successful investing, US investment giant Warren Buffett is a shining example of how you can make your money grow through capitalization.

â€œMy wealth came from a combination of living in America, some lucky genes and compound interests,â€ he once wrote (CNN).

And if you take a look at the examples of Buffett’s portfolios, you’ll notice that he’s mostly invested in dividend-paying stocks, which offer another form of capitalization.

My wealth came from a combination of living in America, some lucky genes, and compound interests. – Warren Buffett

One of the best things you can do, if you’re ok with a little bit of risk, is to invest in a mix of stocks, mutual funds, and ETFs that pay dividends. A popular ETF or exchange-traded fund in Canada is the Vanguard VFV, which tracks the US S&P 500 Index.

The reinvested dividends you earn will generate further dividends, and the compound dance continues.

Let’s take a look at historical data from the S&P 500 as an example. Suppose you invested \$ 100,000 from 2013 to 2017 in an index fund that mimics the S&P 500.

The following table shows what this would look like without (without) and with (with) reinvestment of dividends:

S&P 500 Index Dividend Reinvestment Gains
Year % gain without % gain w Final balance without Final balance w
2013 27.54% 30.50% \$ 127,540 \$ 130,500
2014 10.68% 12.94% \$ 141,161 \$ 147,387
2015 -1.44% 0.58% \$ 139,129 \$ 148,242
2016 7.32% 9.66% \$ 149,313 \$ 162,562
2017 16.95% 19.42% \$ 174,621 \$ 194,131

The reinvestment of dividends amortized your loss in 2015 and allowed you to almost double your initial investment in five years.

If you regularly contribute to your equity portfolio in a thoughtful way and reinvest your dividends, your average portfolio growth has the potential to look very green.

In the long run, you might not see the same kind of growth that Buffett has over the course of his career. But he can attribute his great success to smart investing and the power of capitalization. And you can do the same.

If investing on your own is intimidating you, there are plenty of new technologies that do the heavy lifting for you and lower the cost of investment fees.

Wealthsimple is an automated investment service that makes automatic adjustments to your portfolio in response to risk, so you don’t have to worry. But if you still want to discuss your investment mix, there are portfolio managers available to address your concerns.

Whether you’re saving for the short term or investing for the long term, compound interest is your best friend. So give it a hug and let it work for you.