Compound interest can help you grow your wealth. Learn what compounding interest means and walk through examples showing how you can increase your return on investment using this little- understood concept.
What Is Compound Interest?
Compound interest adds interest to the original investment called the principal. So, you earn interest on your interest gain. Think of it as reinvesting the interest earned instead of withdrawing it at the end of the period. Some funds accrue interest daily, maximizing your earning potential.
How Compound Interest Works
This example applies the compound interest formula to an investment scenario. Interest is earned on both the amount you invest and the interest you earn. In real-world investments, compound interest may occur daily, monthly, quarterly, semi-annually or annually. This depends on how the fund is managed. Now, let’s move on to the example.
Ani puts her money into an index mutual fund for three years. For an investment of $5,000, let’s determine the return on 10% interest, compounded annually.
To calculate the answer, use the annual compound interest formula. Here’s what it looks like:
A = P (1 + r / m) mt
A is the value we are solving for, the future value
P is the initial investment, which is $5,000
m stands for how often the interest is compound during the period. One stands for once a year in this example.
t is total years (periods) of the investment = 3 years
r is the interest rate of 10%
Note that m and t are exponents. (Denoted by ^ in Excel and in the example below.) Solving for A goes as follows:
A = $ 5,000 (1 + 0.10 / 1)^ 1*3
We can ignore the 1 for the number of times compounded since it doesn’t change the outcome.
A = $ 5,000 (1 + 0.10) ^3
A = $ 5,000 (1.10) ^3
A = $ 5,000 * 1.331
A = $ 6,655
We can see from the example that the original amount invested has increased from $5,000 to $6,655 after three years with a steady interest rate of 10% compounded on a yearly basis.
Compound Interest and Investing in Index Mutual Funds
An index fund tracks the movement of a common stock market index. There are mutual funds and ETFs that follow this methodology. Indices that funds target include the following:
1. Dow Jones Industrial Average
2. Standard & Poor’s 500 Index
3. FTSE
4. Nikkei
5. Toronto Stock Exchange
An index gives a snapshot of a particular market. The Nikkei provides a look at the Japanese economy and the FTSE tracks stock movements in the U.K. These measures are reported by business pundits who use them to commentate on the status of the world economy.
Investors in Canada buy index funds from major banks and credit unions as well as online banks.
Canadian Index Mutual Funds
RBC Canadian Index Fund is a Series A fund offered by BlackRock Asset Management Canada Ltd. It’s designed for investors looking for long-term capital growth. It diversifies the portfolios of investors and minimizes tax impacts. Those who invest in the fund watch their principal and interest compound, maximizing their returns.
The TD e-Series Index Funds is another index mutual fund available in Canada. This fund has two options:
TD Canadian Index: MER 0.33%
TD Canadian Bond Index: MER 0.50%
Example Showing Impact of Reinvesting Interest Earned
Investor 1 reinvests his interest back into the indexed mutual fund or ETF. Investor 2 withdraws the income but leaves the principal intact.
The XYZ fund gives a steady 10% return for five consecutive years. Here is what each investor has accomplished at the end of that time.
By saving his money, Investor 1 can earn $5,526 more than Investor 2. This is the power of compound interest in investing strategy. When you take out a loan, compound interest benefits the lender. However, using compound interest and abstaining from withdrawals can increase your wealth.
