Power of Compounding – Have you ever wished to earn more money without putting in much effort? Or are you worried about saving enough for retirement and your childโs education? Thereโs a simple way to achieve these goals if youโre willing to learn how to put your money to work for you.
Itโs called compounding, and it can help you grow your money exponentially over time. Letโs explore the power of compounding and how you can use it in your investments.
What is Compounding?
โCompound interest is the eighth wonder of the world. He who understands it earns it, and he who doesnโt pays it.โ
Compounding means that the returns or interest you earn on your investment become part of your invested capital. When you reinvest your earnings, they start earning returns too. This creates a chain reaction, generating returns on your returns as long as your money stays invested.
There are two types of interest: simple interest and compound interest.
- Simple interest is paid only on the money you invest (the principal).
- Compound interest is paid on both the principal and the accumulated interest.
Example: Ram vs. Shyam
Letโs say two investors, Ram and Shyam, each invest โน1 lakh at 10% per annum for 10 years.
| Particulars | Ram (Compound Interest) | Shyam (Simple Interest) |
|---|---|---|
| Principal invested | โน1,00,000 | โน1,00,000 |
| Rate of Interest | 10% | 10% |
| Duration (years) | 10 | 10 |
| Amount at maturity | โน2,59,374 | โน2,00,000 |
| Difference | โน59,374 |
Ram earns โน59,374 more than Shyam because his interest was reinvested each year.
How Does Compounding Help in Wealth Accumulation?
The key to compounding is time. The longer your money stays invested, the faster your wealth grows.
For example, if you invest โน10 lakhs at 10% per annum:
| Years | Amount (โน Lakhs) | Compounding Effect (โน Lakhs) |
|---|---|---|
| 5 | 16.1 | 6.1 |
| 10 | 25.9 | 9.8 |
| 15 | 41.8 | 15.8 |
| 20 | 67.3 | 25.5 |
| 25 | 108.3 | 41.1 |
| 30 | 174.5 | 66.1 |
After 30 years, your money grows to โน1.745 croresโmore than 17 times your initial investment.
Parameters That Determine the Power of Compounding
Three main factors affect how much your money grows:
1. Compounding Rate
The interest rate you earn on your investment. Higher rates mean faster growth.
| Investment Avenues | Rate | Maturity Amount (โน) |
|---|---|---|
| Savings Account | 4% | 1,48,024 |
| Debt Funds | 8% | 2,15,892 |
| Equity Funds | 12% | 3,10,585 |
| Shares | 16% | 4,41,144 |
2. Time Duration
The longer your money stays invested, the more it grows.
| Years | Maturity Amount (โน) |
|---|---|
| 10 | 2,59,374 |
| 20 | 6,72,750 |
| 30 | 17,44,940 |
| 40 | 45,25,926 |
| 50 | 1,17,39,085 |
3. Tax Rate
Taxes reduce your returns. The less tax you pay, the more you keep.
Applications of Compounding
Compounding is powerful in finance and investment:
- Bank Fixed Deposits: Letting interest accumulate instead of withdrawing it every month gives you a higher amount at maturity.
- Mutual Funds: Growth options reinvest profits, allowing your investment to grow faster than dividend options.
Key Rules for the True Benefit of Compounding
- Start Early: The earlier you start investing, the more time your money has to grow.
- Be Disciplined: Set financial goals and invest regularly, no matter how small the amount.
- Be Patient: Long-term investments benefit the most from compounding. Let your money grow without frequent withdrawals.
The Bottom Line
Compounding means earning interest on interest, leading to substantial growth in your investments and savings over time. The best way to benefit from compounding is to start saving and investing as early as possible. The earlier you start, the greater the benefit.
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Frequently Asked Questions
Q: What is the difference between simple and compound interest?
Simple interest is paid only on the principal. Compound interest is paid on both the principal and the accumulated interest.
Q: How can I maximize the power of compounding?
Start investing early, invest regularly, and let your money grow over a long period.
Q: Can compounding work for small investments?
Yes! Even small, regular investments can grow significantly over time due to compounding.
Q: Is compounding only for stocks and mutual funds?
No. Compounding works in any investment where returns are reinvested, including savings accounts, fixed deposits, and more.
Disclaimer: This blog is for educational purposes only. The securities/investments quoted here are not recommendatory.
