Power of Compounding? All you need to know
In the previous article, we discussed what are asset classes and their types. In this article, we will discuss the power of compounding.
Compounding refers to earning interest on the already earned interest on your investment. The money earned from the returns is employed to increase the value of the investment.
If you have a long-term investment, compounding can be beneficial even if you invest a small amount of money consistently in any given form of investment.
The power of compounding allows you to receive considerable returns over a long period.
In simple terms, compound interest occurs when you earn interest on your principal amount, which is added to the original principal amount.
Raising the potential interest for the next cycle; that is, when interest is added to the principal amount, it increases the base for the subsequent interest to be generated.
The power of compounding, however, is not limited to compound interest. It also includes the concept of delayed gratification, in which you add what you earn to the initial amount. It is usually in the later stages that the magic works.
Comparison of an investment under the principles of simple interest and compound interest:
Say you have invested Rs 1,00,000 each in two investment instruments, A and B. Scheme A and B offers 10% simple and compound interest per annum, respectively.
The period of the investment is 20 years.
Scheme A: The principal amount being Rs 1,00,000 and rate of interest 10% p.a. The simple interest for each year is 10% of Rs 1,00,000, which equals to Rs 10,000. So, at the end of 20 years, the total interest accumulated will be 10,000×20 = Rs 2,00,000. Thus, the final value of your investment will be Rs 1,00,000 + Rs 2,00,000 = Rs 3,00,000 after 20 years of the initial investment.
Scheme B: The principal amount is Rs 1,00,000, and the interest rate is 10% p.a.
In year 1, the compound interest will be 10% of Rs 1,00,000, which equals to Rs 10,000. Thus, the new principal for year 2 becomes Rs 1,00,000 + Rs 10,000 = Rs 110,000.
Now the next lot of 10% interest will be calculated at Rs 110,000, which will be equal to Rs 11,000. Thus, the new principal amount becomes Rs 110,000 + Rs 11,000 = Rs 121,000.
Similarly, for year 3, the interest is 10% of Rs 121,000 = Rs 12,100. And this process continues. In this way, using the compound interest formula, at the end of 20 years, the value of your investment will stand at Rs 672,750.
(Note: the compound interest formula is A=P(1+(r/100)) ^n, where A= amount received at the end, P = initial principal, r= rate of interest, and n= number of periods).
The money invested in the scheme offering compound interest has become more than 6.5 times the initial principal. The investment is worth three times the initial principal in the simple interest scheme.
The difference is more than double. The difference will keep increasing as the period of investing is increased further. Compounding magic will work to blow up the size of your investment multifold.
Power of compounding in mutual funds
Due to the numerous benefits mutual funds provide, they have become a popular financial instrument in recent years. The power of compounding, an integral aspect of how mutual funds work and generate exponential returns over time, is one of the advantages.
The idea behind a systematic investment plan is to take advantage of the compounding effect by investing a small amount of money at regular periods over a lengthy period.
The amount invested grows enormously. For example, to create your retirement corpus, you may start a monthly SIP of ₹5000 and invest for 30 years at 15% projected returns. As you reinvest your money, it will rise enormously.
Using a SIP calculator, we find out that the final value of the corpus is Rs 3.64 crores, with a total investment of Rs 18 lacs over 30 years.
You can reach this whopping amount because of the magic of compounding or what we can call the “power of compounding.”
Key rules for investing
- Start early: The earlier you start, the more time you give your investments to grow. So, beginning early is an important step.
- Be regular: In case of a SIP, be disciplined, and you will see your corpus grow. Be it only Rs 1000, but invest it regularly.
- Be patient: Patience is the key. We know that compounding shows its magic in later years, so be patient with your investment.
Consult an expert advisor to get the right plan for you