The Power of Compound Interest
Why do we invest our money? Well, one of the key reasons is compound interest – meaning, the money we invest today has the ability to grow if placed in the proper investment accounts. The idea is that if we invest $100 today at a 5% annual interest rate, it will grow to $105 in a year. If you then take that $105 and re-invest it yet again at 5%, in another year you will have $110.25, and so on. Making our savings earn more money is the fundamental reason why we invest and by increasing our savings via monthly, pre-authorized deposits, we can help increase our savings on an even larger scale.
Let’s see an example outlining the power of compounding interest by using a monthly pre-authorized withdrawal from your bank account, within an RRSP or a TFSA:
Growth of Savings Over 30 Years
(From Mawer Investment Management’s How Compound Investing Works, illustration as of April 27, 2020)
As you can see from the table above, by investing an initial $10,000 and adding $500 per month (that’s $6,000 per year) at a 5% rate of return, your investment has tripled within 40 years. Not too bad at all.
Now let’s add a little twist – try to increase your contributions by $20, $50, or $100 a month on an annual basis. Just like your cost of living increases by 1% to 2% every year, your savings should do the same because, let’s be honest, $1 dollar of goods today will not be worth $1 dollar of goods in a year.
Let’s see what this additional increase can look like. This chart illustrates the benefits of increasing your savings on an annual basis, partnered with the power of compounding interest; the results are impressive!
Growth of Savings Over 30 Years
Returns$20/Month$50/Month$100/Month7%$260,737$651,841$1,303,6836%$228,119$570,298$1,140,5965%$200,394$500,986$1,001,972
Assumes you increase by $20/month, $50/month & $100/month once a year for 30 years and that you have enough TFSA contribution room for the above increases.
(From A Wealth of Common Sense, illustration as of November 13, 2020)
In the above scenario, the initial investment is $6,000 or a one-year max contribution into a TFSA. Based on the assumption that you are planning to raise your monthly pre-authorized deposit from $20 in year one, to $40 a month in year two, and so on, you can see that in 30 year’s time, you would save approximately $260,000 with a 7% rate of return. By increasing that annual monthly deposit to $100 per month, you can save as much as $1.3 million!
A mortgage, car payments, school tuition – we all have expenses and retirement can look different for each of us. Increasing your savings by $1,200 a year is a little high on the savings spectrum and may not be an option for everyone. However, $240 savings per year may be doable! The truth is that your retirement success is based on how much you save, so if you can start saving today, even a little each year, your savings will grow, giving you a few extra dollars to spend in your retirement and the peace of mind knowing you are secure.