All of us want to be rich in the shortest time possible. We can become rich when our money works for us. Compounding makes our money work for us. The magic of compounding works on the principle that your initial investment earns returns/ interest and then the returns/ interest also start earning returns/ interest as it gets reinvested. Your initial investment grows fast.
How is compound interest different from simple interest?
The mathematical formula for calculating compound interest is
A = P (1 + r/n) ^(n*t)
Simple Interest is calculated as
where A – Value of the amount, P- Initial Investment ,r – Rate of Return, t – duration of the investment, n - number of times interest is compounded per year
The difference is that compound interest is payable on initial amount invested and on the interest earned in the previous time periods whereas simple interest is payable only on the initial amount invested.
Compounding was considered as the 8th wonder of the world by Einstein. Let us see why he thought so-
Consider the following example where Raman has invested a sum of ₹ 10000 today in an investment product that fetches 5% p.a. (Inflation, Taxation etc. are not considered here). Suman started investing the same amount albeit 10 years later. You can see that Raman's principal amount has gone up to ₹ 26,533 whereas Suman has accumulated only ₹ 17,103.
Consider another example - In one scenario, you make an investment of ₹ 20,000 in 2017 whereas in the other scenario you invest ₹ 20,000 in 2017 and add ₹ 2,000 every year for the next 20 years. In both investments you earn an interest of 5% p.a. (excluding inflation and taxes). At the end of 10 years, in scenario 1, you would have earned about 70% and at the end of 20 years, your invest has has more than double the initial investment. In scenario 2, at the end of 10 years, your wealth is three times the initial investment amount and at the end of 20 years, your investment is more than six times the original investment. All you did was invest for a long-term and invest incrementally. It is not too much hard work but more of discipline and rational behaviour.
Time – Invest as early as possible. Do not think that you are too young to invest or think about the future. Just like the early bird catches the worm, the earlier you invest the more rewards you reap.
Stay Invested – Do not withdraw money unless it is an emergency and there are no other means for funding. You should not use the invested money for paying off personal loans, credit card dues or buying luxury items. It is important to keep away from such frivolous expenses.
Grow your investment – No matter how tiny the amount is, incremental investments do wonder to the wealth building process. Set aside some amount from your income for investment purposes.
As you can see, compounding is a powerful tool. It can do wonders to your wealth if you save and invest in the right manner.