The Power of Compounding
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Most of us work really hard to earn money. This money helps us to put food on the table, lets us buy clothes and enjoy the things that life has to offer. But have you ever thought that when you work so hard for money, is money working hard for you as well? Yes. Your money can work hard for you, and it is only possible due to compounding.
Compounding is a simple but powerful concept. It is nothing but the process where you earn interest on the interest that you initially made on the principal invested amount.
Compounding works wonders in the long run, and as time passes, your investments can earn returns, which helps your investment to grow exponentially.
When the interest rate is added to the principal amount, it is called compound interest. The accumulated interest is further added to the principal, and the interest is calculated on the principal amount along with the accumulated interest.
The process is repeated until the time you hold the investment.
The compound interest formula is
A = P (1 + r/n) ^ nt
Here, P = principal amount, r = rate of interest per annum, n = number of times in a year the interest gets compounded, and t denotes the number of years.
Hence, we see that time is the most crucial factor in compounding.
Compound interest is not the only type of interest. Simple interest rate is another. Simple interest rate considers the initial principal and the principal with the interest component is not taken into account.
The formula of simple interest rate is p*r*t /100.
Let us take an example to see the difference between the simple interest rate and compound interest rate. Let us assume that the Rs.50,000 is the principal, the rate of interest is 10%, and the period is five years.
| Compound Interest | Simple Interest | |
| Principal | 50,000 | 50,000 |
| Rate of interest | 10% | 10% |
| Years | 5 | 5 |
| Amount accumulated | Rs. 80,525.50 | 25000 |
| Difference | Rs. 55,525.50 |
From this example, we see that due to the application of the compound interest, you land up with Rs. 80,525, which is around Rs.55,000 higher than the amount accumulated through simple interest.
In the first instance, due to the compounding, the interest that was received in the subsequent years was also added when computing the interest for the next period. However, in the second case, the interest was calculated on the initial principal of Rs. 50,000 only.
The rate of interest is one of the main factors that affect the power of compounding. If an investment gives 12% rate of returns while another option provides 8% rate of return, the investment option fetching 12% rate of return will help to grow your wealth faster.
Let us see the impact of different rate of return on a principal amount of Rs. 10,000 in five years.
| 6% | Rs. 13,382.26 |
| 8% | Rs. 14,693.28 |
| 10% | Rs. 16,105.10 |
| 12% | Rs. 17,623.42 |
| 15% | Rs. 20,113.57 |
The longer we stay invested, the higher is the power of compounding. Let us understand the effect of time, say 30 years on compounding. We will see how Rs. 1 lakh grows over 5 years, 10 years, 15 years etc.
| Amount accumulated | Grows by | |
| Initial Principal | 1,00,000 | – |
| 5 years | Rs. 1,61,051.00 | Rs. 61,051.00 |
| 10 years | Rs. 2,59,374.25 | Rs. 98,323.25 |
| 15 years | Rs. 4,17,724.82 | Rs. 1,58,350.57 |
| 20 years | Rs. 6,72,749.99 | Rs. 2,55,025.18 |
| 25 years | Rs. 10,83,470.59 | Rs. 4,10,720.60 |
| 30 years | Rs. 17,44,940.23 | Rs. 6,61,469.63 |
From this chart, we can see that by doing nothing at all, the principal amount of Rs. 1 lakh grows to Rs.17.45 lakh in 30 years. Also, if we pay a little more attention, we will see that the effect of compounding is the highest between the 25th to 30th year. While the principal increased by Rs.61,051 in the fifth year, it increased by Rs.6.61 lakh in the last five years. Hence, the longer the time tenure, higher will be the effect of compounding.
But staying invested for long is not a child’s play. It requires discipline and patience. Sometimes not doing anything is harder than doing something.
To conclude, the best way to take advantage of the power of compounding is to start investing as early as possible and invest consistently throughout the years.
Tags: compounding, compound interest