How compound interest works (and why starting early wins)

Compound interest is the closest thing personal finance has to a cheat code — if you start early. It's also the quiet force destroying people who carry high-interest debt. Here's how it actually works.

What compound interest is

Simple interest pays you a return only on your original principal. If you invest $1,000 at 6% simple interest, you earn $60 every year — forever the same $60, no matter how long you hold it.

Compound interest pays you a return on your principal plus all the gains you've already earned. In year one, you earn 6% on $1,000 — that's $60. In year two, you earn 6% on $1,060 — that's $63.60. In year three, 6% on $1,123.60 — and so on.

It doesn't sound dramatic at first. But over decades, the difference becomes enormous because you're earning returns on a number that keeps growing — even without adding another dollar.

The snowball effect

Think of a small snowball rolling down a long hill. At the top, it grows slowly because it's small. By the bottom, it's picking up huge amounts of snow with every rotation because it's large. The growth accelerates — not because conditions changed, but because the base got bigger.

That's compound interest. The longer the hill (time), the more spectacular the result at the bottom. The important insight: the last few years of a long investment horizon do more work than the first decade combined.

The numbers: $200/month at 6% annual return

Let's make it concrete. You invest $200 per month consistently, earning an average 6% annual return (compounded monthly). Here's what you end up with:

Look at that last row. You contributed $72,000 of your own money over 30 years — and ended up with over $201,000. Nearly $130,000 of that was generated by compounding alone. The money made money, which made more money.

Now compare years 20 and 30: just 10 additional years added over $108,000 to the final balance — more than the entire 20-year result by itself. The last decade did more work than the previous two decades combined.

Why time beats amount

The instinct is to think: "I'll invest more later to catch up." The math says that rarely works out.

Someone who invests $200/month starting at 25 and stops at 35 (10 years, $24,000 contributed) and then lets it sit until 55 ends up with more money than someone who invests $200/month from 35 to 55 (20 years, $48,000 contributed).

Why? Because the early investor gave their money 30 years of compounding. The later investor gave theirs 20. The early investor contributed half as much in dollars but got an extra decade of the snowball rolling.

The best time to start was yesterday. The second best time is today. Even a small amount invested now beats a larger amount started years later.

Accounts that make compounding work harder

Taxes are the enemy of compounding — every time your gains are taxed, the base you're compounding from is smaller. This is why registered accounts exist:

• A TFSA lets your gains compound completely tax-free — no tax on dividends, capital gains, or withdrawals
• An RRSP lets your gains compound tax-sheltered (you pay tax eventually, but only on withdrawal)
• An FHSA (for first-time buyers) combines both benefits

Holding investments inside these accounts rather than in a taxable account can mean tens of thousands of extra dollars over a long time horizon, simply by keeping the full gain compounding year after year.

The flip side: compound interest working against you

Everything above applies in reverse when you're the borrower instead of the investor. Credit cards in Canada typically charge interest in the 19–22% range, compounded daily on any balance you carry. That's a savage rate.

A $5,000 credit card balance at 20% interest, where you only make minimum payments of roughly 2% of the balance:

• Takes approximately 11–12 years to pay off
• Costs roughly $5,000–$6,000 in interest — nearly as much as the original balance

The math that grows wealth when you're investing shrinks it when you're carrying high-interest debt. Paying off 20% credit card debt is equivalent to earning a guaranteed 20% return. No investment consistently beats that. High-interest debt should almost always be paid down before investing.

Good debt vs. bad debt

Not all debt is the same. A mortgage at 5% or a student loan at 6% is manageable alongside investing — especially when registered accounts like RRSPs and TFSAs earn compounding returns in the same range. Credit cards and high-interest lines of credit at 19%+ are a different beast entirely. Prioritize those first.