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Have you ever heard the expression “money makes money?” We could say that this is real, thanks to the magic of compound interest. This concept is widely used in finances. Compound interest is the interest calculated on the initial amount you borrowed or saved and on the accumulated interest earned or charged in the previous period. Too complicated? Let’s make it simple.
Do you remember Paul, the friend who bought the house recently? Now, he is saving money for a new project, Paul and his wife are going to have a baby! They have $10,000 to put into a Tax-Free Savings Account (TFSA) and Paul will deposit $100 monthly for 15 years to increase the savings and guarantee that this account will pay for their baby’s college in the future.
If we just calculate the amount saved, without interest, in 15 years they will have $28,000 in their bank account. But, if we include the compound interest in this statement, the situation changes.
Let’s say that Paul chooses a TFSA account that is paying 2.4% interest per year. At the end of 15 years, considering this interest rate, they will have $ 36,012.13, thanks to the magic of compound interest.
Still confused? We made a table showing the bank balance’s progression:
Compound Investment
| Year | Year Deposits | Year Interest | Total Deposits | Total Interest | Balance |
|---|---|---|---|---|---|
| 1 | $ 1,200.00 | $ 258.37 | $ 11,200.00 | $ 258.37 | $ 11,458.37 |
| 2 | $ 1,200.00 | $ 293.76 | $ 12,400.00 | $ 552.13 | $ 12,592,13 |
| 3 | $ 1,200.00 | $ 330.01 | $ 13,600.00 | $ 882.14 | $ 14,482.14 |
| 4 | $ 1,200.00 | $ 367.14 | $ 14,800.00 | $ 1,249.28 | $ 16,049.28 |
| 5 | $ 1,200.00 | $ 405.16 | $ 16,000.00 | $ 1,654.44 | $ 17,654.44 |
| 6 | $ 1,200.00 | $ 444.11 | $ 17,200.00 | $ 2,098.55 | $ 19,298.55 |
| 7 | $ 1,200.00 | $ 484.01 | $ 18,400.00 | $ 2,582.56 | $ 20,982.56 |
| 8 | $ 1,200.00 | $ 524.87 | $ 19,600.00 | $ 3,107.44 | $ 22,707.44 |
| 9 | $ 1,200.00 | $ 566.73 | $ 20,800.00 | $ 3,674.16 | $ 24,474.16 |
| 10 | $ 1,200.00 | $ 609.60 | $ 22,000.00 | $ 4,283.76 | $ 26,283.76 |
| 11 | $ 1,200.00 | $ 653.51 | $ 23,200.00 | $ 4,937.27 | $ 28,137.27 |
| 12 | $ 1,200.00 | $ 698.49 | $ 24,400.00 | $ 5,635.76 | $ 30,035.76 |
| 13 | $ 1,200.00 | $ 744.56 | $ 25,600.00 | $ 6,380.32 | $ 31,980.32 |
| 14 | $ 1,200.00 | $ 791.74 | $ 26,800.00 | $ 7,172.06 | $ 33,972.06 |
| 15 | $ 1,200.00 | $ 840.07 | $ 28,000.00 | $ 8,012.13 | $ 36,012.13 |
Every year Paul will deposit $1,200 in the TFSA account (year deposits column) and the bank will deposit the income from the interest earned (year interest column). Added to the initial deposit made of $10,000, interest and deposits together increase the balance, as shown in the balance column.
Year by year, the compound interest makes money grow faster and the amount of interest paid gets bigger. The interest is paid based on the bank balance and this is the reason why every year Paul will receive a higher amount from the bank.
The same idea applies when you are financing a car or taking out a loan, but in these cases, the bank will be charging you interest for the use of their money, until you pay everything back.
Working with a personal loan example, where you take out a loan of $2,000 and intend to repay it in 12 months. Not considering any interest rate for the repayment, the monthly parcel is around $166.67, right? But financial institutions charge interest rates for any type of loan you get, and it can be more or less affordable, depending on your credit score.
Let’s consider an interest rate of 20% in this transaction. The repayment schedule will look like the table below:
Compound Payment
| Month | Start Balance | Principal | Interest | Payment |
|---|---|---|---|---|
| 1 | $ 2,000.00 | $ 151.94 | $ 33.33 | $ 185.27 |
| 2 | $ 1,848.06 | $ 154.47 | $ 30.80 | $ 185.27 |
| 3 | $ 1,693.60 | $ 157.04 | $ 28.23 | $ 185.27 |
| 4 | $ 1,536.55 | $ 159.66 | $ 25.61 | $ 185.27 |
| 5 | $ 1,376.89 | $ 162.32 | $ 22.95 | $ 185.27 |
| 6 | $ 1,214.57 | $ 165.03 | $ 20.24 | $ 185.27 |
| 7 | $ 1,049.55 | $ 167.78 | $ 17.49 | $ 185.27 |
| 8 | $ 881.77 | $ 170.57 | $ 14.70 | $ 185.27 |
| 9 | $ 711.20 | $ 173.42 | $ 11.85 | $ 185.27 |
| 10 | $ 537.78 | $ 176.31 | $ 8.96 | $ 185.27 |
| 11 | $ 361.48 | $ 179.24 | $ 6.02 | $ 185.27 |
| 12 | $ 182.23 | $ 182.23 | $ 3.04 | $ 185.27 |
| End | $ 0.00 | $ 0.00 | $ 0.00 | $ 0.00 |
Twelve payments of $185.27 will become $2,223.23 at the end of a year. It means that the financial institution will be charging you $223.23 for the use of their money during the repayment period.
Looking carefully the table, it is possible to see the compound interest working. The first column is the total amount due to the financial institution. The two columns, principal and interest, show how much of the monthly payments are destined to reduce the amount you owe and how much interest you are paying.
At the beginning, the interest paid is higher than at the end. Do you know why? This is because the interest is calculated based on the total amount of the principal you still owe that month. In the first month, the interest is from the $2,000 due, and in the last month, the interest is calculated from the $182.23 you still owe to the financial institution.
The compound interest is present in several financial activities in our life. Make sure that you look carefully at your contracts, savings, and investment accounts to have the best return on your investment. Or to save when borrowing money. No one is more interested in your financial health than you!
FlexFi Inc. is not a financial advisory firm.
This article is for informational purposes only and is not a substitute for individualized professional advice.
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