Compounding works for both guaranteed and non-guaranteed investments.
How does compounding work with a guaranteed investment?
Let's say you have $10,000 to invest for three years in a Guaranteed Investment Certificate (GIC). You know you'll earn 3.4% interest. The 3.4% return goes into your GIC account once a year. In other words, it compounds annually. If you just let the interest stay there, you are reinvesting it. If you keep reinvesting, here's what you'd make over three years:
GIC You invest $10,000.00 End of Year 1 $10,340.00 End of Year 2 $10,691.56 End of Year 3 $11,055.07
How does compounding work with a non-guaranteed investment?
What if you invested $10,000 in a mutual fund for three years instead? You might find it goes up 5% in the first year, but then it loses 1% the next year. In year three, it gains 7%. It also pays you income each year in the form of distributions. If you decide to reinvest your distributions into more units, here's what you'd gain or lose each year:
Mutual Fund You invest $10,000.00 End of Year 1 $10,500.00 End of Year 2 $10,395.00 End of Year 3 $11,122.70
The Rule of 72: A quick way to estimate the effects of compounding
This is a quick, rough way to estimate how long it will take you to double your money with compound interest. Simply divide the number 72 by the interest rate you earn each year, and that's the number of years you'll need. The Rule of 72 is not exact, but it works pretty well, as long as the interest rate is less than 20%.
Example: Let's say you have $5,000 invested at 6% per year. You divide 72 by 6 and get 12. By the Rule of 72, you'll double your money in about 12 years if you let your interest compound.
Remember: Compounding can really work for you
The longer the time that you invest, the more benefit you'll see.
Use the at Fiscal Agents to see the effects of compounding.
Content in this section is provided in partnership with the Investor Education Fund, a non-profit organization promoting financial literacy to Canadians. To find out more go to GetSmarterAboutMoney.ca.