How Money Makes Money: Interest, Capital Gains, & Dividends Made Simple
The investing world is confusing by design and selling financial advice is big business.
Banks derive much of their profit from advising people who would rather not deal with the details of their own financial planning.
Your banker loves when you ask for investing advice because that’s a chance for them to sell you high commission products.
That’s a big part of why I started this blog.
I want to give you the tools you need to invest on your own and start to build wealth for your family.
So, if you’ve never invested before, or if you’ve been letting someone else handle your investments on your behalf, then this article is for you.
In the next 500 words, I’m going to teach you exactly how your money makes money when you invest.
If you can wrap your head around these basic investment concepts you will be well on your way to starting your DIY investing journey.
How Does Invested Money Grow?
Despite what you may have heard, there are only 3 ways that invested money can make more money - Capital Gains, Interest Income, & Dividend Income.
Let’s break each form of investment income down.
Capital Gains
Buy low. Sell high.
Let’s imagine that you bought one share of Royal Bank stock at $50 and decided to hold onto it for a while.
Years later, you’re browsing through the finance section of the newspaper and you realize that the price of RBC stocks has shot up to $200.
That is what we call $150 of capital appreciation.
Simply put, capital appreciation is the difference between the purchase price of an asset and its current market value.
There are many technical reasons why prices change over time, but that is far beyond the scope of this blog post. For an in-depth explanation of the mechanics that move the financial markets read/listen to A Random Walk Down Wall Street by Burton Malkiel.
So on paper, you’ve made $150, but as far as your bank account is concerned you’re no richer - yet.
Capital appreciation is the unrealized increase in the value of an asset.
However, a capital gain is what you put in your pocket once you sell that asset at a higher price.
Tax Benefits for Capital Gains
Capital gains are the preferred source of income for many investors for two major reasons.
Capital gains can be offset by capital losses. This means that under the right circumstances, an investment that has lost value for you can be used to reduce your tax liability on a different investment that has gained value for you.
Capital gains are taxed more favourably than regular income. In Canada and the United States, you pay your regular marginal tax rate on 50% of your capital gains. So, in our example from above, we would have to pay tax on $75 of the $150 capital gain that you made. The other 50% is all yours tax-free. 😎Not too bad.
Interest Income
Whenever you take out a loan, eventually you have to pay back whatever you borrowed plus a little extra. That little extra is called interest.
However, as an investor, you’re not the borrower - you’re the lender.
Believe it or not, banks and other businesses borrow money from investors all of the time. These lending opportunities exist through a variety of different financial products, each with their own pros and cons.
You can generate interest income by keeping your money in a savings account, by purchasing a guaranteed investment certificate, or by investing in bonds.
How Is Interest Income Taxed
Regardless of the investment vehicle you choose, interest income is always taxed at your marginal tax rate.
That means interest income is taxed in the same way that your 9-5 income is taxed.
This is one of the main drawbacks of interest income - especially if you are in a higher tax bracket. While interest is more predictable than any other form of income, it also has the least favourable tax treatment.
Dividends
Dividends are a share of business’ profits that are paid back to investors.
Not all companies pay a dividend.
Dividends are generally paid by large, well-established companies with stable earnings (earnings is a fancy word for “profit”) who have already reached a certain level of maturity as a business.
Dividends are usually paid quarterly, but each business has its own fiscal year, so payment schedules tend to vary.
Dividend Rate vs Dividend Yield
Generally, when you see a company’s dividend rate on a stock quote, that is their annual dividend rate - i.e.: How much money you would make per share if you were an owner through all four quarters.
The “Dividend Yield” is another common statistic that investors should be familiar with.
The dividend yield is the dividend rate divided by the stock price.
For example: if you buy one share of Royal Bank for $100 and it pays a $5 dividend, it would have a dividend yield of 5%.
⚠️ A word of caution to investors chasing high yields - Numbers can be deceiving!
If a stock has a very high dividend yield it may be due to a recent drop in the stock price.
To explain, let’s revisit our Royal Bank example from above…
If the price of Royal Bank suddenly dropped from $100 down to $50, but the dividend rate remained the same ($5), now the dividend yield of Royal Bank would be a whopping 10%.
This isn’t to say that this scenario is good or bad.
This is just something to be aware of when you are researching dividend-paying companies. If you notice that a particular company has a very high dividend yield, do some research to find out why.
Dividends Are Not Guaranteed
If the business is doing poorly, its dividend may be in trouble. Remember, dividends come from profit. Once the profits dry up, so do the dividends.
Dividends, unlike interest, are not guaranteed. A business is not obligated to pay a dividend, so it’s important to check up on the health of any company before you invest in them for their juicy dividend yield.
All that being said, if you do find a great dividend-paying company then you’re in luck.
Dividend income is taxed more favourably than regular income because the business has already paid taxes on the profits that the dividends come from.
If you want to learn more about the details on dividends, stay tuned for my Dividend Deep Dive article (coming soon).
Parting Thoughts
Each different type of investment income has its own pros and cons. Hopefully, this article has helped you get a better understanding of how your investments actually make you money.
Now, equipped with this information the next question must be “how do I start investing?”
Well, if you’re new to the stock market, I suggest you read this article next: Stock Market 101