Compound interest is a beast. It’s so powerful that it can make or break your finances. Do you know the inside out of compound interest and how to employ the best compound interest investment options to make the beast work for your long-term wealth?
Being a disciplined saver is not nearly enough for building long-term wealth. Hiding your savings under the mattress doesn’t generate any interest, not even simple interest.
Putting your savings in a high interest savings account can help you earn about 2.5% annually. This number is based on the top 5 best savings accounts in Canada as of March 2019. Sadly, with an average annual inflation rate in Canada of about 3.14%, in the long run we will lose not only all our compound interest from savings but also our initial capital.
Note that the average annual inflation rate of 3.14% is calculated based on inflation data from 1915 to 2019 for Canada. In 2018, average inflation rate is about 2.4%. This is also about what you could get from some of the best savings account. In bad years, inflation can be substantially higher than the average figure.
How can compound interest boost your finances?
Long-term well-diversified investment is the way to make compound interest work in our favor. A good benchmark number is an average annual return of 8.5% delivered by the S&P 500 Index from 2008 to 2017 (including the 2008 financial crisis with a drop of -37% in the S&P 500).
This index tracks a huge well-diversified American business and was used by Warren Buffet in his famous 10-year bet against the best stock-picking professionals. If you haven’t read the story, I strongly recommend reading it on pages 11-14 in Berkshire Hathaway 2017 Annual Report. It’s truly an eye opener.
Applying the rule of 72, an average annual return of 8.5% will double an investment every 8.47 years. Let’s make this number a rounded 10 years to be on a more conservative side and account for some investment fees as well as other costs.
If you’re 30 years old now and have $10,000 to invest in the S&P 500, you’d get to $20,000 when you’re 40, $40,000 when you’re 50, $80,000 when you turn 60. And if you can still enjoy 20 more years of life, the initial $10,000 you invested when you’re 30 would turn into a beasty $320,000 when you blow your 80 candles.
Now wake up! Back to when you’re 30 with $10,000 in your bank account, would you burn it in a Caribbean vacation or a quarter of a brand new car? Those are certainly nice-to-have, but should you prioritize them over your long-term investment after knowing the power of compounding?
When does compound interest break your finances?
Credit card debt
The exact same compounding math that applies to the growing of your return also applies to the growing of your credit card debt. After the 21-day grace period, credit cards usually charge an annual interest rate of 19.99% compounded daily.
The rule of 72 tells us that with this sky high interest rate, credit card debt will double itself every 3.6 years! That means if you’re in debt with $10,000 today and you only pay the minimum balance every month, in the next 4 years you’ll find yourself in debt with more than $20,000.
This is not a joke. Don’t pay the monthly balance in full and you’ll find yourself buried deeper and faster in the mass of credit card debt.
No investment with a reasonable risk that our stomach can digest will steadily deliver that same rate of return year after year. That’s why it’s a no brainer to pay off all your credit card debts as soon as possible.
Lenders sometimes offer very low or even 0% interest for 3-6 months to attract your debt. Don’t take this chance to buy more and become more indebted. Instead take the chance to have an interest break for all of your credit card balances. Move your balance to the credit cards with the lowest interest rates you can find.
The tax that we have to pay for a gain in savings interest or investment return effectively reduces our return in a compounded way. Say you earn 4% interest rate but have to pay 25% of this gain to the government, then the effective compound interest rate you earn is now 3% instead of 4%.
If your government allows, always optimize the allocation of your tax advantage accounts wisely to avoid or defer paying tax.
In Canada, any gains made in a TFSA account is completely tax free, so you still get to keep your 4% compounded year after year.
Gains made in an RRSP account is taxed at the time of withdrawal, thereby giving you the chance to compound that 4% as long as you like until you take out the money or reach 71 years old. Plus the tax-return money from RRSP contribution can be put into a TFSA to compound tax free.
Mind the annual contribution limit for these tax advantage accounts and optimize them wisely.
This is another compounding creature that always hurts your finances. In simple terms, inflation means the money in the future will not buy as much as it does today.
With an average annual inflation rate of 3.14%, applying the rule of 72, your money under the mattress will lose all of its value in less than 24 years. Unlike tax shelter options, doesn’t matter what you do, your money will always lose value to inflation.
Best compound interest investment options for your hard saved money
Fundamentally, in an environment where average annual inflation is 3%, any savings or investment option that returns less than 4% a year is a long-term loser due to the combined hit of inflation and tax.
Best savings accounts in Canada right now pay about 2.5% interest. For this reason, a savings account is not where we should plant and grow our long-term wealth.
It should only be a place for us to park our money temporarily. Use cases for a savings account may include accumulating a greater sum to do something else (such as for a down payment, home renovation, vacation) or holding the cash portion of our investment allocation.
You might be a disciplined saver and a true believer of savings interest like Claire. However, sad truth is, stop buying matcha latte using your savings interest money is not nearly enough. If we want our money to truly earn more valuable money for the long run, we need to beat the negatively compounded inflation and tax rate by investing our money in some investment opportunities that can generate more than 4% a year.
Unfortunately, that’s not a small rate to beat. The not so bad news is that companies can generally pass the rising costs down to consumers, thus stocks still have a chance to keep up the pace with inflation. A great low-cost stock investment option is index and ETF investing. Resale and rental value of real estate also increase over time to keep pace with a general price rising.
On the fixed-income side, it’s not too good for bonds because while inflation usually triggers interest rates to rise, bond prices and interest rates tend to have an inverse relationship. I’m a thirty-something DIY investor, so not a huge fan of fixed-income investment (just yet). But I’m aware that investors can purchase inflation-indexed bonds to hedge against inflation.
We’ve seen how compound interest can make or break our finances.
Staying away from consumer debts and investing as much as we can is a MUST if we want to be financially better off.
In my next post, I’ll talk more about the “make” side of compound interest. What do you think is the more important factor in growing your money: time in the market or timing the market? We’ll cover this topic in-depth next week.