“What is the point of studying all this? It will never help us later on in our lives.” Sounds familiar? Well, that is something that all of us have asked our teachers or parents at some point of our school life to present the redundancy of learning a difficult math concept. One such concept is compound interest.
The concept of compound interest can help turn a few bucks into a respectable corpus over a period of time – so much so that the money reinvested might even be greater than the original amount.
Want to understand the power of compounding and its application in the financial world? Then read on!
What is Compounding?
Compound interest, as we are all aware, is when one receives interest not only on the principal sum but also the interest that is reinvested. While this might seem like a rather simplistic understanding its power will be realised when the amounts are invested in for longer durations of time. With every successive year of reinvesting the interest, the size of the corpus increases, and the interest earned for the succeeding year also increases, all other things remaining the same. Compounding is similar to the multiplier effect.
For example, an Rs. 1,000 investment at an annual interest rate of 8% per annum will grow to Rs. 50,000 in 20 years. The same investment at a rate of 10% can, in 20 years, fetch you Rs. 63,000. And, by staying invested for a longer period, your capital will earn more money for you.
Watch this video to learn more about compounding :
How is Calculation of Compound Interest Done?
Compound interest is paid on the accrued interest i.e. on the principal amount and the additional deposits and interest.
What is the Relation Between Time Value of Money and Compounding?
The time value of money is crucial for the investor to realise the benefits of compounding. As the money can earn compound interest, when invested, it has more value in the present than in the future. The time value of money is calculated using the future value, the interest rate and the time frame. Each time frame factors in the number of compounding periods within it.
Benefits of Compounding
The benefits of compounding are as follows –
- Greater accumulation of wealth as returns grow through geometric progression.
- Bridges any shortfalls in target corpus.
- Helps preserve the value of capital and overcome the vagaries of inflation.
How is Compound Interest used in Mutual Funds?
Mutual funds are designed to ensure that investors make gains when the NAV per unit rises. Over longer durations of time, the increase in the value will be more tangible and the risks will be averaged out. The investor will earn dividends on the fund invested as well as the dividend reinvested (if opted for a dividend plan).
An interesting thing to note is that with each passing year, the value of the earliest investments will see the maximum growth. The older investment commands a higher value.
How Does One Leverage the Power of Compounding?
- Start early – every day lost is an opportunity lost to benefit from the power of compounding.
- Invest in riskier instruments such as equities and mutual funds and hold it for longer durations. One can beat inflation and also build a substantial corpus that is tax free if the investment is done right.
- Use online SIP calculators and other online tools to understand the kind of returns that one will receive at the end of the investment period.
- Avoid withdrawing the sum invested or the interest earned, unless absolutely necessary.
- One must invest regularly and monitor their investments periodically.
- Mutual funds offer one of the easiest means by which one can experience the power of compounding.
Some Final Thoughts
The power of compounding is the secret to wealth creation. The quote by Benjamin Franklin summarises the power of compounding accurately – “it is the stone that will turn all your lead into gold. Remember that money is of a prolific, generating nature. Money can beget money, and its offspring can beget more.”
Frequently Asked Questions
- What are the most important factors that influence the growth of one’s investment?
The two pillars of growth are time and return – the more of either will ensure that the investment grows faster.
- Is compound interest on interest?
Yes, indeed. The interest is calculated not just on the principal amount but also on the interest earned.
- What is the time value of money?
The time value of money refers to the concept that one’s money is worth more now than at a future date. This is by virtue of its potential earning capacity. The application of this concept rests in the fact that any amount of money is worth more the sooner it is received as it can earn a higher amount of interest.