Market Insider By Peter Tremblay 716 Views

Investing: Understanding compound interest and compounding growth

For many people, the concept of finance is not only difficult to understand but equally boring when explained in detail—especially concepts such as inventory management systems, taxation and accounting law. However, one concept in finance that everyone needs to pay close attention to and possibly even get excited about is compounding.

There’s nothing arguably more exciting than just watching your money grow. That is basically the concept of compounding, whether it’s the compounded growth of your stocks portfolio or compound interest. In finance, the word interest can be easily confused since it is used in many different scenarios but generally, any amount of money paid by a borrower to a lender for money loaned is called interest.

Once you begin saving some money from your monthly income—with the help of a savings calculator—you can open a savings account at the bank to deposit these savings. Your bank would then borrow this savings from you and pay you a monthly interest on it. Likewise, if you borrow money from the bank, you would be mandated to equally pay monthly interest on the borrowed sum.

This gives a clear understanding of what interest is and there are basically two types of interest: simple and compound. Simple interest is simply your interest rate multiplied by your principal. For example, if you deposit $2,000 in a saving account that has a 10% interest rate, it means you would receive $200 extra as your interest at the end of each year—if you didn’t make any withdrawals.

While simple interest seems to be quite enticing, it is far better to receive compound interest. Essentially, compounding interest is accumulated interest. Using the above example, in the case of compounding interest, your account balance would not only grow annually, but the rate at which it grows will also increase every year. So, after the first year, you’d have gotten $2,200 because of the 10% interest rate, while after the second year, you’ll get another 10% interest but this time on the $2,200 balance. Essentially, you would have received $2,420 after the second year.

The more exciting and lucrative option is compound interest and the longer you leave your money, the more extra income you’ll receive on it. Remember that, unlike simple interest where you just gain a fixed interest rate every year, compounded interest allows you to earn interest on your previous interest year-on-year. But it is not always as simple as it sounds. The “multiplying factor” is based on the compounding rate which can be either daily, weekly, quarterly, monthly or yearly.

A daily compounding rate would mean the interest paid would be added to your daily balance, while for monthly or annually, it would be added at the end of the month or year, respectively. Compounding is often used in retail bank investments, loans (whether mortgage, auto or student loans), savings accounts and credit card debt.

If you’re familiar with compounding interest, then you should also know what compound annual growth rate (CAGR) is. This simply shows you the current annual growth rate when a figure increase over a certain period of time. For example, if you had an investment portfolio of $1,000 and in 3 years, you now have $9,000. The CAGR over that 3-year period would be 23.86%

The big question is, can compounding actually make you rich? Well, you can become rich over time once you can take advantage of compounding, but the key is to start saving money and investing it as soon as possible. It can be difficult to stay motivated about investments when you’re young but those are the times when you can invest enough money that would grow over time.

According to Albert Einstein, compounded growth is a financial phenomenon and those who fail to take advantage of it, only have themselves to blame.

But how then can you make compounded growth work for you? There’s the short term and the long-term approach. For the short-term approach, all you just have to do is put your money in a savings account with good compound interest. However, the long-term approach is the most lucrative option.

A long-term investment is the best strategy for those who are nearing retirement and fortunately, Canadians already have a natural place for their long-term savings plan.

 The Tax-Free Savings Account (TFSA) is the best investment account in Canada where you can keep interest yielding investments tax-free. If you plan to grow a retirement fund or nest egg, it would be best to invest in dividend stocks. The best part of this investment type is that you can easily hold on to your investment for a long period of time, not minding the market volatility. TFSA investors enjoy a lot of compounding growth on their investments which grows exponentially over time.