Power of compound interest
November 14, 2013
We would all like to have more money, wouldn’t we? It’s achievable with a little patience and the power of compound growth. How does compound interest work?
Most people are familiar with the concept of simple interest. Simple interest is money earned on the principle. For example, if you put $1,000 in a savings account that generates 2% annually, you would earn $20 in interest each year. At the end of 40 years, you would gain $800 of interest, for a total savings of $1,800.
Compound interest allows you to gain interest on the initial principle amount plus the interest that you have already earned. Earning interest on interest adds up over time, and allows your money to grow faster than it would using simple interest. If we used the same example as above, but instead invested the $1,000 at 2% compounded annually for 40 years, the total savings would be $2,208. While just a simple example, you can see the savings potential. If you want to see your money grow, contributing regularly will allow your money to gain more interest and more return.
Invest early and regularly
To maximize the power of compounding, starting early is critical. The longer you are able to let compound interest work in your favour, the better. Contributing regularly will also help your money grow faster.
For example, if you invested $5,000, annually at the age of 45, at a rate of return of 5%, until the age of 65, your total savings would be $173,595, however if you invested the same amount annually at the same rate of return at the age of 25, your savings could grow to $634,199 by the age of 65. Investing the same amount regularly at an earlier age, allows you to accumulate interest early and get it working for you over the long term.
Setting up a pre-authorized contribution (PAC) is one of the easiest ways to reach your long-term savings goals. A PAC plan allows you to have your contributions automatically transferred from a specified account periodically, usually monthly, to a specific savings vehicle, such as an RRSP or TFSA. A PAC allows you to leverage the principle of compound growth. Plus, by investing small amounts on a regular basis, as opposed to a large annual lump sum, it will put less strain on your cash flow.
Investing any amount of money at a higher rate will lead to higher returns - that’s common sense – but did you know that compound interest can add up significantly when you invest at a higher rate of return? If you invested $1,000 at a 3% annual rate of return, your investment would grow to $2,427 after 30 years. If you invested the same amount for the same period of time at a 5% annual rate, your investment would grow to $4,322. You could earn $1,895 more with only a 2% difference in interest rate. Even just a slight difference in your rate of return can make a remarkable difference over a long period of time, so be sure to compare your investment options to help your savings grow faster.
Talk to a Coach
Everyone has different priorities and goals. A Libro Coach will help you find a comfortable contribution schedule based on your financial situation.
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