Money Club for Young Adults
How to Use Your Money - The Power of Compounding
There is only one way for most people to become wealthy and that is slow. That is because compounding takes time. Most people want to get rich quick. This leads them into risky 'investments', most of which don't work out. This then results in get poor quick.
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The irony to all this? Young people don't have as much time as they think. As any old person already knows:
'The days are long and the years are short.'
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As you can see from the napkin drawing, compound interest is kind of boring in the short term. However, as it slowly works its magic, compound interest becomes very exciting over time. Earning interest on your interest results in exponential growth in your investments over time. The earlier you get started, the quicker you will get to the exciting part - the 'hockey stick' part.
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And what is better than regular compounding?
Tax-free compounding. Canadians today have many great options to grow their investments tax-free: TFSA, FHSA, RRSP and RESP. ​​
Compound interest can be a hard concept to grasp. We have two different videos to help you.
Compounding - 4 Key Takeaways
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Time: the earlier you start the sooner you gain the advantage of time.
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Rate of Return: the higher the better.
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Be an owner. Invest in broad based index funds.
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Reinvest your earnings: don't spend them; instead, let them compound.
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Capital preservation: don't take excessive risks that can lead to large losses.
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For most people success is not going to come mostly from rate of return. It is going to come from time - starting early matters.
What is Compounding? A Real World Example
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When our third child was born we opened up a group RESP. At inception, we contributed $2,000 for each child, which was a total of $6,000. The government added their 20%, which was $1,200. So we started that first year with $7,200.
We made no other contributions. All 3 of our kids are now almost done university. What did the $7,200 grow into over the past 20 years? $235,000, or $78,000 per child. Because the funds are taxed in the hands of the kids, they are largely tax-free.
For each child, our $2,000 contribution has grown into $78,000. Tax-free. That is what compounding is. ​
The Power of Compounding: A Second RESP Example
Initial contribution = $2,500
Government top up (20%) = $500
Keep doing this same thing each year for 20 years.
Annual rate of return = 8% (invest in broad based equity ETFs)
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Total value of RESP after 20 years = $151,000
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Total contributions = $50,000 ($2,500 x 20 years)
Government top-up and investment gains = $101,000
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The contributions have tripled in value. Effective CAGR = 9.5%
Don't have the money?
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One strategy is to ask family members for help. Parents. Grandparents. Aunts/uncles. If family members know their help is going to go to permanent savings they might be more inclined to help out.
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Gifts: For Christmas and/or birthdays tell family members to stop buying 'stuff' for the kids (and you) and instead help contribute to the child's RESP (or your TFSA, FHSA or RRSP).
With the power of compounding, their help/gift will be the best kind - it will be the gift that keeps on giving.
Compound Interest Calculator
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This tool can be used to determine how much your investment can grow over time using the power of compound interest.
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A quick way to determine how long an investment will take to double in value is to divide 72 by the annual rate of return. For example, an investment that earns 10% per year will take 7.2 years to double in value.
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