The snowball effect: Understanding the benefits of compounding interest

Is it better to invest a smaller amount for a longer time or a larger lump sum later on?

To answer that question we need to consider the concept of compound interest. Breaking it down to its most basic elements, compound interest calculates interest both on your initial investment amount, and on interest earned since that initial investment.

Even Albert Einstein reportedly weighed in on its importance: “Compound interest is the eighth wonder of the world – he who understands it, earns it; he who doesn’t, pays it.”

Far better to be on the earning side of that equation! And that’s where the rule of 72 comes in.

“The Rule of 72 helps determine how long it will take to double your money,” explains Tracy Trotter, an advisor with Coastal Community Credit Union in the Comox Valley. “Simply divide 72 by your rate of return to determine the number of years required to double your initial investment.”

For example, dividing 72 by an interest rate of two per cent determines it will take 36 years to double your money. However, dividing it by an interest rate of six per cent shows it will take just 12 years to net the same result.

At the same time, it’s important to remember that investments with a greater rate of return are often higher risk, Trotter notes. “When choosing investments, it’s important to select ones that won’t keep you up at night.”

(For an additional planning tool, you can also use the rule of 72 to determine the impact inflation will have on your savings. For example, if inflation is two per cent, $1 today will be worth $0.50, or half, in 36 years.)

Now that we understand what compound interest is, why is it important?

The “snowball effect” of compound interest underscores the benefit of starting to save and invest early, whether that’s in an RRSP, RESP, Tax-free Savings Account or other investment, Trotter explains.

Even if you invest a little each month, the results of compound interest add up over time – or snowball – so you’ll earn more in the long run compared to someone who invests a single larger amount later on.

Why? Because each time interest is paid, it gets added to the snowball, so you’re earning on both the initial investment and the interest generated. Each time the interest is calculated, the amount it’s paying on has grown larger.

To learn more about planning for your financial future, including harnessing the power of compound interest, contact Tracy Trotter in the Comox Valley.

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