The Power of Compounding

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The concept of compounding is not new to most of us. In simple mathematical terms it is any interest earned/accrued from a deposit or loan, which subsequently is reinvested or added back to the principal. So the interest added also earns interest. It is for this reason compounding is often referred to as interest on interest.

The concept of compounding is of vital importance when it comes to investing. With strong abilities to make your investments grow and fetch greater rewards, its power cannot be underestimated. To understand its impact on investments, let us begin by understanding how it is calculated.

  • Basic Calculation of Compound Interest

Compounding ploughs back any earnings from an investment back into it. It lets you earn on the principal as well as on the accrued interest, unlike simple interest where you earn only on the principal. This makes your investment grow exponentially over time. Your money actually works harder for you. Here is a quick illustration to understand how it works.

The calculation of compound interest is based on two vital factors- the principal and the interest accrued.  Let us assume an initial investment of Rs. 50,000 in a bank fixed deposit at 10% per annum interest. This is how your investment would grow over a period of 20 years.

  Amount invested 10,000
  Interest rate 10%
     
Year Principal Interest Earned Accumulated Value
1 ₹ 10,000.00 ₹ 1,000.00 ₹ 11,000.00
2 ₹ 11,000.00 ₹ 1,100.00 ₹ 12,100.00
3 ₹ 12,100.00 ₹ 1,210.00 ₹ 13,310.00
4 ₹ 13,310.00 ₹ 1,331.00 ₹ 14,641.00
5 ₹ 14,641.00 ₹ 1,464.10 ₹ 16,105.10
6 ₹ 16,105.10 ₹ 1,610.51 ₹ 17,715.61
7 ₹ 17,715.61 ₹ 1,771.56 ₹ 19,487.17
8 ₹ 19,487.17 ₹ 1,948.72 ₹ 21,435.89
9 ₹ 21,435.89 ₹ 2,143.59 ₹ 23,579.48
10 ₹ 23,579.48 ₹ 2,357.95 ₹ 25,937.42
11 ₹ 25,937.42 ₹ 2,593.74 ₹ 28,531.17
12 ₹ 28,531.17 ₹ 2,853.12 ₹ 31,384.28
13 ₹ 31,384.28 ₹ 3,138.43 ₹ 34,522.71
14 ₹ 34,522.71 ₹ 3,452.27 ₹ 37,974.98
15 ₹ 37,974.98 ₹ 3,797.50 ₹ 41,772.48
16 ₹ 41,772.48 ₹ 4,177.25 ₹ 45,949.73
17 ₹ 45,949.73 ₹ 4,594.97 ₹ 50,544.70
18 ₹ 50,544.70 ₹ 5,054.47 ₹ 55,599.17
19 ₹ 55,599.17 ₹ 5,559.92 ₹ 61,159.09
20 ₹ 61,159.09 ₹ 6,115.91 ₹ 67,275.00
         

A simpler mathematical way of expressing the above is by applying the formula:

A= P {1+r/n} nt

Where P= Principal or initial amount invested, r= rate of interest, n= number of times the interest is compounded in a year,                 t= the number of years,                A= Final amount after compound interest is added.

So your 20 year fixed deposit would fetch you Rs. 67,275.

Impact of Compounding Over Time

The impact compounding has on an investment is directly related to its tenure. The longer the investment tenure, the higher are the gains. Compounding works exponentially over time. With the interest being added on to the principal, which in turn becomes the new principal, in the long haul it fetches you more. We could plot the above table on a graph to understand this.

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The above graph shows an upward trend as the years pass on. More the years, more the interest cycles the deposit is put through. You thereby stand to earn much more from your investment.

  • Maximising Benefits- The Early Bird Catches the Worm

Maximising returns from investment is what almost all of us seek. And the way ahead to achieve this is to let your investment grow over a period of time. Having understood that compounding yields more when your investment is for a longer tenure, it pays to start investing early in life. Starting early has its share of advantages, such as:

  • The earlier you start the more time your money has, to plough back the interests. And more the years, for compounding to have an impact on your investment.
  • Saving for a financial a goal or commitment? Starting early is the key. It would mean you invest lesser, and let compounding work its way on your money. The later you start saving towards a goal, the more you may need to pump in as investment.

Featured Image: Pexels

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