Power of Compounding

Money makes more money which in turn makes further money. Read the article to understand how compounding works.

· 5 min read
Power of Compounding

Most investors know only a few of the basic rules of investing like - “Buy low, sell high.” “Don’t put all your eggs in one basket.” “Don’t try to guess the market or take on more risk than you can afford.” But far fewer people know about the “power” of compounding and how the returns can grow exponentially with that.

The compounding effect on a regular investment of a small sum of money over a long period of time can accrue a huge amount of money.Today in this article, we are going to see the power of compounding, see examples of how compounding works, how it is different from simple interest and what strategies you should follow to take advantage of compounding.

What is Power of compounding?

Power of compounding is a money multiplier strategy in which the interest earned on principal is reinvested so as to earn interest on interest leading to a growth in the value of investment exponentially.

How does compounding work in investing?

Suppose, you have invested Rs. 1,00,000 (this is called principal) in an investment instrument and hold it for 5 years without withdrawing the entire principal or part of it over 5 years. Suppose 10% is the interest rate promised. We will see how the principal grows when the interest is compounded annually and when it is not (simple interest).

Comparing Compound vs Simple Interest

                          Compound interest

Simple interest

Amount at beginning of the year

(Rs.)

Year

Amount at end of the year 

 (Rs.) 

Interest earned

(Rs.)

Amount at beginning of the year

(Rs.)

Amount at the end of the year

(Rs.)

Interest earned

(Rs.)

 

Fixed

1,00,000 (P)

1

1,00,000(1+10%)


= 1,10,000

1,10,000 -1,00,000


=10,000

1,00,000 (P)

1,00,000(1+10%)


= 1,10,000

1,10,000-1,00,000

 

=10,000

1,10,000

2

1,10,000(1+10%)


= 1,21,000

1,21,000 - 1,10,000
 

=11,000

1,10,000

1,20,000

10,000

1,21,000

3

1,21,000(1+10%)


=1,33,100

1,33,100 - 1,21,000


= 12,100

1,20,000

1,30,000

10,000

1,33,100

4

1,33,100(1+10%)
 

=1,46,410

1,46,410 -1,33,100


=13,310

1,30,000

1,40,000

10,000

1,46,410

5

1,46,410(1+10%)
 

=1,61,051

1,61,051 -1,46,410


=14,641

1,40,000

1,50,000

10,000

***** Here P indicates the principal amount or your initial investment.

In case of compound interest, we see that interest is earned both on the principal amount as well as on the interest of the previous year. For example, in year 2, the compound interest earned= 10% of principal amount +10% of the interest earned in year 1 = 10% of Rs. 1,00,000 + 10% of  Rs. 10,000 = 10,000+1,000 = 11,000. Likewise, it also happens in consecutive years.

Key Learnings from Compound vs Simple Interest analysis:

- The compound interest earned increases gradually every year, that is Rs.10,000 in the first year followed by  Rs. 11,000, Rs. 12,100, Rs. 13,310 and Rs. 14,641 in the consecutive years. This implies that the amount accumulated at the end of the year or the closing balance grows exponentially.

- Simple interest earned is the same every year, which is 10% of the principal amount, Rs.10,000 and hence the closing balance increases much more slowly. For example, you can see that the amount accrued at the end of year 5 is Rs. 1,61,051 in case of compound interest compared to Rs. 1,50,000 in case of simple interest.

- Compounding means that by investing small amounts of money consistently over time and leaving them to grow, your return may well be higher over the long term than if you just invest one lump sum and hope that it will rise.

Types of compounding:

Compounding can be daily, weekly, monthly, quarterly, half yearly, yearly. In fact, compounding can be done for any period in a year. We will see what effects these different types of compoundings have on your investment.

General formula for calculating the amount accumulated at the end of “t” years, given by “A”, at the rate of annual interest “i”, compounded for n periods in a year is, A=P (1+ i/n)nt

Suppose i = 12%, P= Rs. 100000, t= 5 years

Case 1:
Interest 12% is compounded yearly, which means, the interest is compounded once in a year or n = 1. A = 100000(1+12%)5 =  Rs.1,76,230

Case 2:
Interest 12% is compounded half yearly, which means, the interest is compounded twice in a year or n = 2. A= 100000(1+12%/2)5 X 2  = Rs. 1,79,080

Case 3:
Interest 12% is compounded quarterly, which means, the interest is compounded 4 times in a year or n = 4. A= 100000(1+12%/4)5 X 4  = Rs. 1,80,610

Case 4:
Interest 12% is compounded monthly, which means, the interest is compounded 12 times in a year or n = 12. A= 100000(1+12%/12)5 X 12  = Rs. 1,81,669

Case 5:
Interest 12% is compounded weekly, which means, the interest is compounded 52 times in a year or n =52. A= 100000(1+12%/52)5 X 52 = Rs.1,82,086

Case 6:
Interest 12% is compounded daily, which means, the interest is compounded 365 times( or 366 in case of a leap year) in a year or n =365. A= 100000((1+12%/365)5 X 365  = Rs. 1,82,194

Thus you can see from the above example,that your investment grows faster when the compounding period increases. You will accrue money the most when the interest is compounded daily as compared to when it is compounded yearly.

Strategies to be followed to take advantage of power of compounding:

Start Early:

Start investing as early as possible and hold it as long as possible to see your money grow exponentially. The more the time, the more is the growth potential. For example, Investor 1, who started at age 22 and invested Rs. 5,000 per month at 8% interest compounded annually, till the age of 50 accumulated far more money than Investor 2, who invested the same money at the same interest rate but from age 40 onwards.

Be disciplined:

You have to keep aside the money religiously every month and  be regular in your payments towards the investment as disciplined contributions work best to create wealth.

Be patient:

Be patient and focus on your final goal. Power of compounding is felt and seen only if investments are allowed to grow at their own pace.

Investment vehicles offering compound interest:

1. Savings Interest: On savings bank accounts, interest is calculated on a daily basis and the money is also entirely liquid.
2. Fixed Deposit: This method is considered most safe and secure.
3. Money Markets: They are a little risky as their rates are market determined and influenced by the economy.
4. Stock Markets or mutual funds: If you invest in the right company, then the stock market can deliver a huge compounding effect, but stock markets are subjected to high market risk.
5. Recurring deposits

Closing Thought

Compounding is an extremely useful tool to grow the wealth of investors but keep in mind, it is equally detrimental for the borrowers as compounding effect also applies for debts, credit cards, mortgages and other loans

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