Compound Interest Explained: How Your Money Works for You

How Compound Interest Works

Simple interest is calculated only on your original principal. Put $10,000 in at 5% simple interest and you earn $500 every year — no more, no less. Compound interest automatically reinvests those gains. In year two, you earn 5% on $10,500, which is $525. Year three, on $11,025 — and so on. It's a snowball that grows with every revolution.

• Principal: the amount you invest upfront.
• Rate of return: the percentage earned each period (annual, monthly, etc.).
• Compounding frequency: how often gains are reinvested — the more frequent, the stronger the effect.
• Time: the single most powerful lever of all.

Compound Interest vs. Compound Growth: What's the Difference?

Compound interest is the term most often used for savings products: high-interest savings accounts, GICs, bonds. The bank pays you interest, that interest is added to your deposit, and it earns interest in turn. It's predictable and (within CDIC limits) guaranteed.

Compound growth applies to investments in stocks or funds, where your gains come from both price appreciation and reinvested dividends. Returns aren't guaranteed, but Canadian and U.S. equity markets have historically delivered compound growth of roughly 7–10% per year over long periods (closer to 5–7% after inflation). This engine powers TFSAs and RRSPs invested in ETFs.

The Rule of 72: A Quick Mental Shortcut

The Rule of 72 is a handy back-of-the-envelope tool: divide 72 by your annual rate of return to estimate how many years it takes to double your money.

• At 4% (e.g., a current GIC): 72 ÷ 4 = 18 years to double.
• At 6% (e.g., a balanced portfolio): 72 ÷ 6 = 12 years to double.
• At 9% (e.g., a historical equity ETF, gross): 72 ÷ 9 = 8 years to double.

As Investopedia notes, this shortcut is an approximation — future returns are never certain — but it gives you an intuitive feel for how powerfully the rate of return interacts with time.

Why Starting at 25 Instead of 35 Makes Such a Big Difference

Here is a clearly labelled hypothetical illustration (not a promise of returns):

• Alex starts at age 25, invests $300/month for 40 years inside an RRSP, with a 7% annual compound return. At 65: approximately $797,000.
• Sam starts at age 35, invests the same $300/month for 30 years at the same 7%. At 65: approximately $368,000.

Both invest the same monthly amount, but Alex contributed for 10 extra years — and ends up with more than twice as much at retirement. Those extra 10 years were largely paid for by compounding returns, not extra contributions. Use our compound interest calculator to model your own scenario.

DRIP: When Dividends Feed the Machine

A Dividend Reinvestment Plan (DRIP) is compound growth made concrete for stock and ETF investors. Instead of receiving your quarterly dividends as cash, a DRIP automatically reinvests them to buy additional shares or units. Those new shares then pay dividends of their own, which buy more shares — and on it goes.

Over 20 or 30 years, DRIP participation can account for a significant portion of your total portfolio value. The Financial Consumer Agency of Canada (FCAC) notes that investors who consistently reinvest dividends tend to accumulate more than those who withdraw them. Most Canadian online brokerages offer DRIPs at no extra cost on eligible securities.

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