What is compound interest? The Canadian beginner’s guide to investment growth

Key details

• What is compound interest? Compound interest is when your interest starts earning its own interest. Not only do you earn money on your initial investment, but on the accumulated returns too, speeding up your growth.
• Is compound interest different from compound returns? Compound returns are the investor’s version of compound interest: your total investment earnings (from capital gains, dividends, etc.) are reinvested to generate even more earnings, accelerating your growth.
• How does compounding work? Its power is controlled by three key elements: your initial and ongoing contributions, your investment rate of return and, most critically, time.
• What compounding helps you do: It speeds up your wealth-building by creating a cycle where the money you earn builds on itself over time.
• The biggest risk to your returns: This powerful growth can be subtly sabotaged. High investment fees act as a constant drain on your returns, siphoning your potential wealth.

The one factor the 1% have mastered (and you can, too)

There’s no single secret to building wealth, but there is one factor that everyone who’s built lasting wealth uses well—and it has nothing to do with complex stock picks or timing the market.

It’s simpler, more fundamental, and undeniable: compounding.

Compounding comes in two forms, interest and returns, and every single Canadian with discipline can make use of them. This guide will show you how.

Getting to know the factor that builds fortunes

At its core, compounding is just a basic cycle, no more complicated than how days add up to weeks and weeks add up to months.

In short: your money earns a return, and that return gets added to your original pile, making it bigger. The next time you earn a return, it’s on that new, larger amount.

This creates the chain reaction that builds wealth. Let's look at its two forms.

Form 1: Compound Interest This is the compounding you see on cash. It’s the interest a bank pays you on your balance in a High-Interest Savings Account (HISA) or on a GIC. First, you earn interest on your principal. Then, you earn interest on your principal plus the interest you’ve already accumulated. It’s a safe and steady, but typically slower, way to grow your money.

Form 2: Compound Returns This is the more powerful engine of wealth creation that you see in an investment portfolio. When you own assets like stocks or ETFs, your returns can come from two sources:

1. Capital Gains: The asset increases in price.
2. Dividends or Distributions: The company pays out a portion of its profits to you as a shareholder.

Compound returns occur when these gains and dividends are reinvested to buy more of the asset, which then generates its own returns. This is the primary way investors build significant, long-term wealth.

How does compound interest work? The three elements of growth.

To put this tool to work, you need to understand the three elements that dictate its power.

1. Your contributions (the building): The more capital you invest—both initially and through consistent additions—the more raw material the cycle has to work with.
2. Your rate of return (the growth rate): The higher your rate of return, the faster the cycle spins. A portfolio earning an average of 8% will grow significantly faster than one earning 3%.
3. Time (the amplifier): In investing and life, it’s the most powerful element. Growth is exponential, so the returns you gain in year 25 of investing can be greater than the first 15 years combined. Time is the amplifier that turns a small effect into a life-changing outcome.

The subtle thief: How high fees steal your future wealth

If compound interest is the tool the wealthy use to build their fortunes, high fees are the tool the banks often use to build theirs—with your money.

Most of the time, it’s a line item on your statement so small you barely notice it—or, if you do, you shrug it off as the cost of growth. After all, a 2% management expense ratio (MER) on a mutual fund doesn't feel like an emergency; neither does a one-time $10 trading commission.

But the longer you pay, the more it leaches from your earnings—year after year after year, compounding their wealth at the expense of yours.

The math: how fees hurt your growth

We know math isn’t everyone's favourite but this one matters so we did it for you.

Let's look at a $10,000 investment over 25 years, earning a hypothetical 7% return before fees.

• With a 2.17% fee (a fee typical of many bank-sold mutual funds in Canada), your investment would have a 4.83% return and grow to $32,519.18.
• But with a 0.42% fee (like what you might pay with a Questwealth Portfolio), that same investment would return 6.58% and return grows to $49,191.82

That is over a $16,000 difference. What would your future self do with an extra $16,000?

Compound interest investing: Where to put this tool to work

Not all accounts are created equal when it comes to maximizing your compound interest. Because there’s more than just fees to consider, there’s taxes, too.

There’s good news, though. As a Canadian, you have registered accounts that come with tax benefits, including:

• Tax-Free Savings Account (TFSA): An account where your investments can grow and compound completely sheltered from tax.
• Registered Retirement Savings Plan (RRSP): Designed for retirement, your contributions are tax-deductible and your investments grow in a tax-deferred environment.
• First Home Savings Account (FHSA): It combines the best features of an RRSP and a TFSA: your contributions are tax-deductible, and your investment growth and qualifying withdrawals for a down payment are all tax-free.
• Registered Education Savings Plan (RESP): A dedicated savings account for your child's post-secondary education. While contributions aren't deductible, your money grows tax-deferred, and the government provides matching grants, supercharging your savings.

Using these accounts ensures that the wealth you are building is yours to keep.

A deeper look: The power of compound returns in your portfolio

The real magic of compound returns comes from a simple action: reinvesting your distributions.

Many stocks and ETFs pay dividends, which are small cash payments made to you as a shareholder. You have two choices: take the cash, or use it to buy more shares.

By automatically reinvesting those dividends (an option available on platforms like Questrade), you put the compounding cycle on autopilot. Each dividend buys more shares, and those new shares then generate their own dividends in the future.