Compound Interest – The Double Edged Sword

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In my first post, I mentioned that I make decisions to buy certain things by weighing having something vs the value of that item in 20 years, with interest, for when I retire. I mentioned buying an Xbox One, let’s say that costs $500. If I spend $500 now, I have an Xbox One, but what if I instead put that money into my S&P 500 TFSA?

Well, it just so happens that I have a Google spreadsheet that tells you exactly what happens right here. The document assumes we invested $500 into the S&P 500, in our tax protected Tax Free Savings Account (TFSA), so we don’t have to pay taxes at all on this. It assumes the particular S&P 500 fund we want to invest in keeps its current fund fee of 0.08%, and inflation runs at 1.5% annually. You’ll see that our $500 investment grows to about $3900.

For me, $3900 can easily be enough to let me live comfortably for a month or two when I decide to retire. So Xbox One now, or 1-2 months of extra retirement in 20 years? As a PC gamer, the choice was easy.

I remember first hearing about compound interest, it sounded like you could turn on the ‘compound interest’ switch and start making serious money. Albert Einstein described compound interest as “The eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”

Compound interest is the growth of your principle investment, and collecting interest on that growth in the next year (or compound period).

To illustrate with another example, let’s assume you have $1000 invested and your investment grows by 10% a year. Here is how that would work over 5 years:

  1. At the end of year one, your $1000 will grow by $100 (10% of $1000) to $1100.
  2. At the end of year two, your $1100 will grow by $110 (10% of $1100) to $1210
  3. At the end of year three, your $1210 will grow by $121 (10% of $1210) to $1331
  4. At the end of year four, your $1331 will grow by $133 (10% of $1331) to $1464
  5. At the end of year five, your $1464 will grow by $146 (10% of $1464) to $1610

Compound interest is the interest that grows off interest you’ve already accumulated. Notice that after 5 years, your investment has grown to $1610, that is the base amount of your assets for year 6. Because of compound interest, it will take just over 7 years for your investment to double at a 10% annual rate of growth.

But compound interest can also work against you. Mortgages and credit card debt are good examples of that. If you have a credit card with an annual interest rate of 30% (the high end of interest rates in Canada currently), that 30% will be applied monthly or even daily by your credit card company. If it is monthly, you will be charged 2.5% (30% divided by 12 months) per month. As credit cards usually have a higher interest rate on overdue balances than most investments can return, this means that you can double your credit card debt in only a few years. This is one of the reasons why many financial advisers suggest paying off all your expensive debt before saving or investing your money.

If you are in the position of wanting to buy a house in Toronto or Vancouver, and happen to have an amazing down payment where you’d ‘only’ need a $500,000 mortgage, what would the (compound) interest be in 25 years? Using online mortgage calculators, at a historically average 7% interest rate the banks will charge you, you’re looking at $550,623 in interest charges alone over 25 years. That is more than double the amount you borrowed.

Compound interest is the only way you can grow your savings and investments, it truly is the engine that drives the value of your savings up. But if you have a tough time controlling your spending, it also has the potential to cripple you in debt and force you to waste your time working only to pay off interest.

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