So, you may have heard this term in the news or in a post somewhere. What is so important about compound interest? What the heck is it? Can you give me an example of compound interest? Here is one:
Part 1: Starting your savings plan
Let’s say, you want to start saving for your retirement. You have zero savings in your retirement fund but have decided to set aside $100 dollars every month, this is an amount you can afford and won’t affect your cash flow too much. If you invest your $100 in a portfolio with a 7% average return paid monthly, you will have $7,159 by the end of 5 years, where $1,159 is the interest earned in your savings.
Part 2: Extending your Investment Term
If on year 5, your friend wants to copy your investing strategy, by year 10 (year 5 of investing for your friend), your friend will have the same amount you had by year 5, this means $7,159. Then, let’s assume you kept saving the same amount from year 5 to year 10 because you and your friends decided to be financially responsible together from now on. By year 10, you will have a total of $17,308 on savings with $5,308 coming from interest. This means that approximately 30% of your total savings is interest gained (on year 10) versus 16% from your friend’s or yourself, in year 5.
Part 3: Your Savings Compounded!
Interest earns interest. Then that interest earns more interest. Then that last interest keeps earning more and more interest. That is compounding, letting your profits earn more interest and being reinvested for a longer period of time. The longer you keep your savings plan the faster your wealth will accumulate!
Online calculators are a great way to forecast your savings. You can create another example of compound interest to reach Financial Independence by using the Compound Interest Calculator from the Ontario Securities Commission. Start compounding today!
