In his essay “Advice to a Young Tradesman” printed in 1748, Benjamin Franklin said:
“Remember that Money is of a prolific generating Nature. Money can beget Money, and its Offspring can beget more, and so on. Five Shillings turn’d, is Six: Turn’d again, ’tis Seven and Three Pence; and so on ’til it becomes an Hundred Pound.”
These wise words illustrate the power of interest compounding, a powerful force that can be used to build long-term wealth when you earn it. But when you pay the interest to your lender, it is the opposite—wealth is reduced.
When you save and accumulate assets, compounding is your best friend, your ally. It plays on your financial team. When you borrow and accumulate debt, compounding is your enemy. It plays against you and your goal of building long-term financial security.
In theory, compound interest is a very simple concept to grasp. We should be earning it (by owning value-appreciating assets). In practice, however—and judging from human behaviour—it looks like most people don’t understand it. People continue borrowing and borrowing until, unfortunately, it is too late.
When Compounding Is Your Enemy
According to an Equifax report, consumer debt in Canada rose to $2.46 trillion at the end of Q1 2024, marking a 3.5 percent increase from the previous year. From this amount, Canada’s mortgage debt represents 74.4 percent of the total ($1.83 trillion debt). Even at low rates, that debt generates a lot of interest that comes out of the pockets of borrowers and goes into lenders’ pockets.Mortgages have a corresponding asset—the household home—which appreciates in time. But a combination of higher balances, higher rates, longer amortization periods, and frequent debt consolidation could erase the benefits and make compounding interest your enemy. Taking out a $500,000 mortgage over 25 years will cost the homeowner well over that amount in total cash outlays.
In the case of non-mortgage debt, the situation could be even more dangerous. According to a TransUnion report, Canadian consumer debt (excluding mortgages) reached around $582 billion by the end of Q1 2024. This includes credit cards, lines of credit, auto loans, and unsecured instalment loans. Credit cards alone represent $114 billion of the total, with an average consumer balance of $4,276. It seems we can’t stop spending. We have fallen in love with spending rather than owning value-appreciating assets.
To put the above figures in context, Canadian tax filers contributed $54.2 billion to RRSP plans in 2022. Canadians owe on credit cards twice what they put in RRSPs every year, and owe on non-mortgage debt balance 10 times their annual RRSP contribution. With higher interest rates and card rates of over 20 percent (combined with compounding debt interest) many Canadians are in trouble. That’s money that could be in their pockets and not those of their lenders. When you let that happen, compounding is your enemy.
However, there is a solution.
Turning the Tables: When Compounding Is Your Friend
Just as compounding is the adversary of the debtor, it is a crucial and important ally of the saver. But there is an important caveat. It only works if the saver saves.How can anyone start saving money and leveraging compounding in a world of infinite wants, multiple spending options, and huge peer and social pressure? The best and easiest way is enrolling in an automatic saving program. We’ll explain the basics of this, but first let’s understand the favourable impact that compounding interest has on your financial well-being when it is your friend.
Below is a table of how much a $ 200-a-month saving program can yield over time at different rates of returns. Longer periods matter, but so does the rate of return. More risk usually means higher returns over longer periods of time. The saving program is automatic, and money can be invested in any asset class you want: stocks, bonds, GICs, mutual funds, ETFs, or a combination of those assets.
A young person investing $200 a month for 40 years can expect to grow those savings to $305,204, even at a return of only 5 percent. At 10 percent, which is a more normal return to expect from a 70/30 stock/bond portfolio, the investor would be left with $1,264,816. At 12 percent, the investor would have over $2.3 million. Starting early makes a big difference.
It’s never too late to start an investment program. As the table shows, an older investor depositing $200 a month and earning 10 percent can build a portfolio of $40,969 in 10 years and $151,874 in 20 years.
Notice how depositing $200 per month, a total of $48,000 in deposits in 20 years, more than triples. Increasing the monthly payment to $500 would yield about $379,684. (Not shown in the table.)
For longer periods the effect is even more dramatic. In 40 years at 10 percent, $96,000 in deposits grows 12 times, becoming $1.26 million. Of course, returns in the stock market (if you choose that route) are not linear. We just want to demonstrate the power of compounding long term. Which do you prefer? The money in your pockets or those of bank shareholders? (It might be a good idea to hang on to your car after it’s paid off.)
| Years | Deposits | 5% | 10% | 12% |
| 5 | $12,000 | $13,601 | $15,487 | $16,334 |
| 10 | $24,000 | $31,056 | $40,969 | $46,008 |
| 20 | $48,000 | $82,207 | $151,874 | $197,851 |
| 30 | $72,000 | $166,452 | $452,098 | $698,993 |
| 40 | $96,000 | $305,204 | $1,264,816 | $2,352,955 |
Switching Interest Compounding: From Debt to Savings
So far, we have discussed how compounding can either play on your team and multiply your savings, or against you and make your lenders rich. How can you make it play for you? Let’s go back to traditions.In 1926, George S. Clason published the book “The Richest Man in Babylon.” He used the phrase, “Pay yourself first.” This means setting aside a fixed amount of your salary or monthly income and automatically putting it to work for you. Today this is relatively easy to accomplish. You only have to set up automatic monthly debits (pre-authorized deposits or PADs) from your bank account to your investment account, and you will get it done.
But in practice many people are reluctant to implement this easy solution. They fear they will be short of money to pay for their expenses and so are reluctant to commit. We have a natural proclivity to spend all we earn, and even spend more with the use of credit cards. There is huge social pressure (i.e., keeping up with the Joneses). People already feel it is impossible to cut expenses and change their lifestyle, not to mention committing to saving. But for anyone looking to improve their financial situation, the key is replacing the pattern. Just get it done. Set it up. Don’t overthink. Even a little amount will suffice to put compounding interest in motion. Just commit, start, then increase.
In a future article, we will share more details about how to convert superfluous spending choices into automatic savings to start building your financial muscles. This will not only put you on the right path, but will help you train your will, exercise self-restraint regarding spending choices, and have more control over your finances—definitely good character traits to develop that will be needed in the future for other important endeavours in life.
