Here's How Compounding Works

Compound interest pays interest not only on the principal, but on the interest as well, increasing the rate at which your money grows.

For example if the interest was compounded yearly and you started with a $100 investment at a 10% interest rate, you'd have earned $10 interest the first year, and would now have $110 at the end of the first year.

In the second year, you would earn interest on $110, giving you $11 in interest in the second year, so at the end of the second year you would now have $121, and so on. So after 20 years you'd end up with $672.75!

Compound interest holds incredible implications for those who start to invest early on in life. The sooner one establishes an investment portfolio, the longer that portfolio will have to earn interest. The beauty of "compound" interest is that one will continuously earn interest ON THE INTEREST WHICH THEY HAD EARNED PREVIOUSLY!

So what are the long-term implications of this? Well, establishing an investment portfolio at an early age means one will not need to invest as much money in order to reach their retirement goals as they would if they started later on in life. As an example, imagine two different people who wish to retire at the age of 60.

The first individual starts young. This 15 year-old begins to save his/her summer wages (let's say, $2,500.00) within an RRSP. This individual continues to contribute this same amount for the next 15 years, and then stops at the age of 30. If this investment portfolio received compound earnings at an annual rate of return of 10%, then this individual would accumulate more than $1.5 million by the time he/she reached the age 60. Pretty incredible, especialy when one stops to consider that this individual only invested $37,500!!!

The second individual started contributing the same $2,500 amount every year, but he/she started at age 30. This person would end up contributing over $87,500.00, and would have only accumulated just over $500,000 by the time he/she retired at age 60.

Here's another stunning example of how compounding inside an RRSP pays off over the long term. To reach a nest egg of $275,000 at age 65, a 20-year-old would only have to invest $1,000 for five years at 10% - a $5,000 investment. Meanwhile, a 31-year-old would have to deposit $1,000 for 35 years (a total investment of $35,000) at 10% to accumulate the same amount of money.

Amral, that sum it up just right...however, I still think they need to give the investment figure a lil bit more for RRSP per year.. in other words, one is restricted to a certain amount per year now if one can contribute more than that figure, should they not be allowed?

Amber i think the contribution limit is based on earnings. It's only high earners that are usually able to put the maximum anyways.

If you put more than your maximum for that year, it can be carried forward to the next year and you wouldn't be able to get any tax benefit for the contributing year. But if it's invested wisely then the long term results is worth it.