The magic of compounding
Perhaps you’ve heard of compounding, also known as “compound interest.” Behind this technical term lies a very powerful concept that can help you accumulate a lot more money in your Registered Education Savings Plan (RESP). How does it work? We can explain!
The “virtuous circle” of saving
The principle of compounding is simple: Generate interest on interest earned over time. Simple interest only generates a return on the amounts you contribute. Compounding is better, as it makes your investments work harder for you. The income earned with your capital over time is reinvested, and then the new income is calculated on this new total amount, and so on. So the effect is exponential!
When applied to your RESP, the compounding process involves a few simple steps:
- You put aside money with your contributions (the capital);
- That capital produces income (e.g., interest);
- The income is reinvested in the RESP;
- Future earnings will then be calculated on this new, higher amount.
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The effect of compounding: Illustrations with figures
To help you understand the concept of compounding, here are a few examples1 of the benefits.
Consider an initial contribution of $2,000 invested at an interest rate of 5%, where interest is calculated once a year. The two tables below provide a comparison of what happens with and without compounding.
With compounding
| 1 year | 2 years | 3 years | |
| Amount on which interest is earned | $2,000 | $2 000 + $100 | $2,000 + $100 + $105 |
| Interest earned | $100 | $105 | $110.25 |
| Your savings | $2,100 | $2,205 | $2,315.25 |
Without compounding
| 1 year | 2 years | 3 years | |
| Amount on which interest is earned | $2,000 | $2,000 | $2,000 |
| Interest earned | $100 | $100 | $100 |
| Your savings | $2,100 | $2,200 | $2,300 |
Even over a short period of time, you can see the power of this technique for effectively boosting the return on your savings.
Now let’s look at a scenario where the initial investment is $10,000 with an interest rate of 4% over 10 years and interest is also calculated once a year.
With compounding
| 10 years | |
| Amount on which interest is earned | $10,000 |
| Total interest earned | $4,802.44 |
| Your savings after 10 years | $14,802.44 |
Without compounding
| 10 years | |
| Amount on which interest is earned | $10,000 |
| Total interest earned | $4,000 |
| Your savings after 10 years | $14,000 |
Over a 10-year period, the actual rate of return is 4.32%. So the compounding technique is particularly good for long-term savings.
Source: Ontario Securities Commission.
Time and consistency working for you
As you’ve seen, time is critical in making the most of compounding. The longer you contribute, the more you can benefit from the “snowball effect” on your savings.
Along with time, consistency is an important factor. With compounding, if you choose to make monthly contributions, each contribution will be added to your capital when interest is calculated. That means more profit each time!
Contribute early to an RESP to maximize your tax benefits
It’s never too early to save. By starting to save as early as possible, you can make the most of the exponential power of compounding.
The best way to do this is to adopt a systematic savings strategy and set up automatic contributions.
The RESP, which allows you to save for a child’s post-secondary education, is a perfect vehicle for compounding, even with small contributions. The beauty of an RESP is that you can get government grants on every dollar you invest. With those grants, every contribution is boosted by at least 30%,2 which increases the amount on which compounding is calculated. So it’s doubly exponential!
To help you build savings into your budget so you can benefit from the effects of compounding, you can download our free, easy-to-use budget template. The Kaleido team is there to assist you every step of the way. Contact a representative for more information about RESPs and all of their benefits.
This simple tool will help you calculate how much your child’s postsecondary education could cost.
Takes about 5 min.
1. The figures in the examples presented in this paragraph are purely random, have no legal value and are used solely to illustrate the concept of compounding and make it easier for readers to understand.
2. Canada Education Savings Grant (CESG) of 20% to 40%. Based on adjusted family net income. Quebec Education Savings Incentive (QESI) of 10% to 20%. Based on adjusted family net income. Some conditions apply. Check out our prospectus at kaleido.ca.
