Dale Jackson

Personal Finance Columnist, Payback Time

An Angus Reid Institute survey this week suggested inflation is forcing Canadians to take drastic steps to make ends meet.

As our dollars erode, it found that most of us are cutting back on spending and delaying major purchases. It also revealed 19 per cent of respondents are deferring or not investing in their registered retirement savings plans (RRSP) and tax-free savings accounts (TFSA).

In many cases, cash-strapped households have no alternative. But those able to choose whether to trim their RRSP and TFSA contributions could be denying themselves the inflation-fighting power of compound interest.

How compounding works

The actual mathematical formula for calculating compound interest is complex and there are plenty of online calculators to do it for you.

In short, it is interest on a principal amount plus interest on the interest as it accumulates over time. The more frequently it compounds, (monthly versus annually, for example) the greater compound interest it generates.

One way to illustrate the power of compounding is to follow what is known as “the rule of 72”. You can find how long it will take the principal amount to double by dividing the interest rate into 72.

At a rate of ten per cent, it will double in 7.2 years. At four per cent it will double in 18 years.

To make things simple, assume your TFSA investments generate an annually compounded five per cent rate of return after inflation. Right now inflation is in the high single digits but will hopefully average out to a lower level over the next 30 years.

Let’s also assume the current value of the investments in your TFSA is \$50,000 and — despite the added burden of inflation right now — you can manage to pull together a \$10,000 contribution each year.

Using one of the many debt calculators available online: After 30 years, your \$350,000 in total contributions will have generated \$563,705 in compounded interest, bringing your total TFSA savings to \$913,705.

An added advantage of having all that money in your TFSA is you don’t have to pay any tax on the compounded returns and they can be withdrawn at any time.

Supercharged compounding in RRSP

Compounding often produces bigger returns in an RRSP because savings amounts are usually higher. However, unlike a TFSA, contributions and returns are fully taxed when they are withdrawn.

On the plus side, you can supercharge the power of compounding in an RRSP by reinvesting the tax refund generated by the initial contribution. The refund amount is based on the tax that would have been imposed if the contribution was never made. If your top marginal tax rate is 40 per cent, for example, your refund would be 40 per cent of the contribution amount.

Reinvesting the refund would generate another refund of 40 per cent of the refund amount, which would generate a 40 per cent refund on that amount…and so on.

All the while, the compounded contribution amounts will be compounding in investments over time.

Compounding cuts both ways

Albert Einstein once said, “He who understands compounding, earns it; he who doesn’t, pays for it.”

Compounding is a double-edged sword that cuts especially hard for those deep in debt. The same basic formula applies to money you owe — and in many cases the rates are much higher.

It’s rare to find a non-mortgage consumer loan with an interest rate below ten per cent. Credit cards often come with interest rates that exceed 20 per cent.

As rates rise, a higher portion of regular debt payments are allocated to interest, with not much left to whittle away at the principal.

In many cases, paying down debt is the best investment you can make. Think of it as generating a guaranteed annual return equal to the rate you are being charged — tax free.