“From $0 to FIRE: The Best Compound Interest Strategies for Gen Z”💰

Are you hoping to retire early in the FIRE movement but unsure how to make it happen in an unpredictable economic market with soaring living costs and an expensive housing market?

Many young Canadians may feel the squeeze, but there is a secret power on your side: compound interest and time. If you leverage compounding interest with time in the right investment formula, it allows you to harness the power of your money, making more money. 

With this smart strategy, your money will roll slowly and consistently, like a turtle in Aesop’s fables, towards your goal of retirement, so that you will achieve financial freedom after retirement.

Think of it like this: first, you have to invest your seed money, which produces annually a small amount of interest from the capital market. Next, you need to let the money grow without withdrawing any money, and then it gradually starts growing more interest. Over a long time, your money will accumulate into big money from that initial seed money. That’s the magic of compounding.

Through this guide, you will learn what compound interest is, why it’s a big deal for young investors like Gen Z, and which type of investment can leverage it strategically. 

What Is Compound Interest?

Compound interest is like a snowball rolling downhill; it starts small but grows bigger and faster over a long time. In basic terms, you will earn not only certain interest annually, quarterly, or monthly from your investment, but also earn interest on interest. The interest and your investment are compounded together based on the compound term.

For example, if you invest $10,000 at a 5.5% annual interest rate, compounded yearly, after one year you will earn $550 in interest, making your total $10,550. In the second year, you will earn 5.5% on $10,550, which includes your initial investment of $10,000 plus the $550 interest. So your interest will be $580.25, and your total will be $11,130.25. In the third year, you will earn 5.5% on $11,130.25, and this cycle will continue as long as you keep the money in the account without withdrawing any funds. 

Over time, your money will grow gradually, but after 10 years, this snowball effect can increase significantly.

👉 Tip:

Use online compound interest calculators to visualize how compounding interest works.

Image from Wealthsimple

Why Compound Interest Matters For Gen Z

As a Gen Z investor, you have a superpower: TIME. The sooner you start investing, the more time your money has to compound, leading to exponential growth. By leveraging compound interest on your investments, you can maximize returns. 

Consider the following tips:

• Choose the right accounts: Look for accounts that offer competitive returns, such as RRSPs, TFSAs, RESPs, high-interest savings accounts, or stocks and bonds.

• Start early: Beginning in your 20s gives your money decades to grow. For example, a $5,000 investment at age 20 with a 5% annual return, compounded yearly, could grow to over $21,609.71 by age 50, even without adding more money. However, if you wait until 30 to start, you would only have $13,266.49 by age 50 and would need to invest more to catch up. 

• Consistent investment: Adding regular investments to your RRSP, TFSA, high-yield savings account, or low-cost index fund can make a significant difference. It may grow slowly at first, but over time it accumulates more and faster. 

• Reinvest earnings: Reinvesting your earnings can lead to higher returns.

• Diversify your investments: Spread your investments across various options to take advantage of different growth opportunities and reduce risk.

• Optimize compounding frequency: Choose accounts that offer more frequent compounding interest for faster growth if possible. 

Image from Investopia

Actionable Strategies to Turbocharge Your Compounding

1. Maximize your TFSA early: A TFSA account can be your primary vehicle for compounding because any investment growth within a TFSA, whether it’s interest, dividends, or capital gains, is completely tax-free. This account is perfect for both short-term and long-term goals.

2. Leverage your RRSP for future tax advantages: While the TFSA is fantastic for tax-free growth, the RRSP offers immediate tax deductions on contributions, deferring taxes until retirement, when you’re likely in a lower income tax bracket. 

3. Invest in low-cost index funds and ETFs: Index funds and ETFs tracking broad markets, like the S&P 500 or TSX, offer diversified exposure with minimal fees.

4. Automate your investment into your accounts: TFSA, RRSP, or FHSA using Robo-Advisors. 

5. Boost your income and savings: Leverage high-income skills and side gigs to generate extra income, prioritize conscious spending to save more money, or negotiate deals to increase investment contributions. 

6. Improve financial literacy: Always educate yourself to understand basic investment principles, market cycles, and tax implications because the economy is constantly evolving.

Pros and Cons of Compounding Interest

Compound interest has the potential to build wealth, but when it comes to loans or credit, it can also increase your debt. This is because interest is calculated not only on the original balance owed but also on the interest that accumulates over time. This creates a compounding cycle where interest keeps adding up until you repay the full amount. 

To avoid this financial pitfall, it is crucial to pay off your credit card balances in full and on time, as well as make regular additional payments on loans such as mortgages or student debt. This will help reduce the total amount of debt and interest you have to pay. Ultimately, you can save a significant amount of money that would have otherwise gone towards interest payments.

👉 Tip: 

Use the rule of 72: Do you want to know how long it’ll take for your money to double? Simply divide 72 by your annual interest rate. For example, with a 6% return, your money will double in about 12 years. This rule provides a fast method to estimate the power of compounding. 

Final Thoughts

Your time is your most valuable asset, and it’s also your greatest ally when it comes to compounding.  By starting early and staying consistent, compound interest rewards you with building lasting wealth and securing your financial future.

To harness the power of compounding, focus on a few key actions: prioritize saving and investing in tax-advantaged accounts like the TFSA and RRSP, automate your contributions to stay consistent, and remember to continuously educate yourself about your investments. 

By doing this, you’re building a habit of financial discipline that will pay off for years to come. 

Whether you’re saving for travel or dreaming of financial independence, compound interest is a powerful tool that can help you reach your goals. So, what’s your next move?

Calculate your potential FIRE timeline using a compound interest calculator and open a TFSA or RRSP account. Share your FIRE journey in the comments below!

DISCLAIMER: This article is for informational purposes only and should not be considered as financial advice.