WHY YOU SHOULD BE FRIENDS WITH COMPOUND INTEREST
When you put something away compounding for a number of years, make sure you can stand that, or the chances of getting out of it with something in your pocket is not very good in terms of interest. — Adrian Mastracci, president of KCM Wealth Management
Summer school isn’t punishment. Think of it as a second chance or bonus education. So whether you’re trying to repair your finances, make more cash or make smarter money decisions, we’re here to help.
This week A lesson in compound interest.
Course Description It’s been called magical. A miracle. The eighth wonder of the world. You’d think it was a supernatural aura or a spectacular monument, but nope, it’s compounding interest.
What exactly is that? Think of it as interest on interest. It ’s interest on your initial principal and then on the accumulated interest. And think of its power like the Force. Depending on how it is used, the power can be good or evil. It can be your friend or your enemy depending on whether you earn it or you pay it.
How to make compounding interest your friend
Time can turn compounding interest into your BFF. This friendship just grows and grows over the years and before you know it, it’s this huge, valuable asset that supports you.
“It’s like a snowball. You start with a little thing and it rolls down the hill and one day, you think, ‘Wow, I have a little nestegg!’ ” says Kelley Keehn, author of A Canadian’s Guide to Money Smart Living.
“We as Canadians, we hate to crunch numbers, but numbers are our friends.”
Let’s say you invested $1,000 and it earned 5% in interest last year. Today, you’d be earning interest on $1,050.
Now, let’s say you left $1,000 in the bank to grow for 30 years with a 5% rate of return, compounded annually; even if you never added any more money, you’d have more than $4,300.
In other words, compounding interest can only be your best bud if you are patient.
“When you put something away compounding for a number of years, make sure you can stand that,” says Adrian Mastracci, a portfolio manager and president of KCM Wealth Man- agement in Vancouver.
“Or the chances of getting out of it with something in your pocket is not very good in terms of interest.”
Our low interest rates have dulled the potency of compounding interest with traditionally safe s avi ngs vehicles such as GICs and bonds. “Fourteen years ago, you got 5, 6, 7% on your GICs. You’d be excited to get 2% or 3% these days. On the plus side, inflation used to be higher so the net to you today is not bad.”
Whether you’ ve invested your money in GICs, term deposits, mutual funds, stocks, bonds, exchange-traded funds, etc., where should you put your compounding interest? How about somewhere it can grow tax-free? “Because interest is taxed at the highest rate, that’s a good reason to put it in an RRSP or a TFSA or an RESP,” he says.
“With a TFSA, you might be better with dividends and capital gains by buying stocks.”
When compounding interest isn’t your friend
On The Tonight Show, Johnny Carson quipped: “Scientists have developed a powerful new weapon that destroys people but leaves buildings standing — it’s called the 17% interest rate.”
Compounding interest isn’t your friend when interest is growing on your debts. The worst is your credit card debt. That’s like a friendship you made on a whim, like someone you met at a bar and at first, it was fun but over time he’s become a huge, stressful drain on your life.
Some of us have little memory of the interest-rate environment that Mr. Carson was joking about some 30 years ago. We are living in a time of record-low interest rates and we also have record high household debt.
Let’s say you use your credit card, which has an 18% interest rate, to buy a $2,000 patio set. If you only made the minimum payment of 2% or $10 a month, through the wonder — or in this case, horror — of compounding interest, you’d spend more than 30 years paying off the set, including $4,931.11 in interest.
This applies to your home purchase as well. “I hosted a show called Burn
My Mortgage,” Ms. Keehn says. “I’d be on the lawn with these families, telling them, ‘With your 25-year amortization at this low-interest rate, did you know you’re going to pay $380,000 in interest over the life of your mortgage?’ And they’d say, ‘ Oh my God! That’s evil!’ ”
Today’s low interest rates are a gift for homeowners; they provide an opportunity to pay down as much principal as possible in these early years when interest eats up most of the payments.
Take advantage of this environment by accelerating your mortgage payments or shortening your amortization.
For example on a $250,000 mortgage at 6% interest on a fixed term with monthly pay- ments, you’ll pay $285,354.78 in interest over 30 years, says BMO. Or, $177,320.98 in interest if you decrease your amortization to 20 years.
For the same mortgage on a five-year fixed term for a 25-year amortization, it’ ll cost you $229,863.58 in interest if you pay in monthly installments. However, if you do accelerated weekly payments (¼ of a monthly payment per week), you’ll end up paying $185,351 in interest. That’s savings of more than $44,500.
“Your best risk-free investment is to pay off your mortgage because you control how much you pay off,” Mr. Mastracci says.
Finally, compounding interest is not your friend when you owe money to the Canada Revenue Agency. Actually, a moderately irritating antagonist can become a Darth Vader level foe.
If you’re late filing your income tax return, the CRA applies a 5% penalty on the unpaid taxes plus an additional 1% for every month the return is late, up to a maximum of 12 months.
Once you’ve been hit with a late-filing penalty, any subsequent late filings could see a 10% penalty on your balance owing plus 2% for every month that it is late, to a maximum of 20 months.
And if you don’t pay, warns tax lawyer Dale Barrett, the CRA has the power to seize your house and your assets or close down your business. No one wants a friend like that. Homework (one thing to do this week): Go on a fact-finding expedition. Can you further reduce your total interest costs and be mortgage-free years sooner? Reach out to your financial institution about your mortgage payment options. Can you make a lump-sum payment against your mortgage principal? Can you increase the frequency of your payments from monthly to bi-weekly? Can you top up your mortgage payments by 10% every year? Reading list The Random Walk Guide to Investing by Burton G. Malkiel.