The Magic of Compounding and How to Use It

We live in a world where we’re used to seeing the rich become richer. Many individuals believe you need to be incredibly smart and make a lot of money to become wealthy. Yet, if you know the power of compounding, it is enough to help you become wealthy.

The Magic of Compounding

Compounding, or the power of compound interest in investment, is a mathematical process by which your investments earn you more money. In simpler terms, compounding investments mean the interest accumulated in a period also earn interest in a next period.

Still confused? Okay, let’s take an example. Assume that you invest Rs 1,000 at an interest rate of 10%. At the end of a year, you would have earned an interest of Rs. 100 and the total amount becomes Rs 1,100. For the next year, interest of Rs. 100 also earn interest at the rate of 10% and if you reinvest the whole amount, you will earn the interest of Rs.110 and Rs 1,210 at the end of two years. At the end of 10 years, you would have Rs 2,594. In nominal terms, your investment has grown 159.4% in 10 years! This is the power of compounding.

Compare this with simple interest, which earns returns only on your capital invested. For instance, if you withdrew the interest you earned every year, you would have made Rs 1,000 in interest at the end of 10 years instead of Rs 1,594.

Now, imagine that instead of Rs 1,000, you had invested Rs 10 lakh. You would have a total corpus of Rs 25.94 lakh! You would have more than doubled your initial investment!

This is how compounding works. It will help if you consider using the principle of compounding to increase the value of your money significantly.

How The Power of Compounding is Effective in Generating Wealth

The power of compound interest works wonders in any form of investment. Compounding magic in investment will work as long as you keep reinvesting your returns. Whether you invest in fixed deposits, mutual funds or equities, the power of compounding will work.

Over the years, the interest you earn will increase, and this, in turn, will make you more money. To make the best of compounding investment, you need to keep three factors in mind: 

1. Principal

The higher your principal amount, the more will be the impact of compound interest. A larger capital will make you more money.

2. Timeline

The real magic of compounding happens in the later years. This is because the interest that you earn becomes larger over time. It is rarely possible to become wealthy overnight. Increasing your time horizon can ensure you reach your goal through the power of compounding.

3. Investment Returns

Compounding investments work better with some asset classes than others. For instance, while fixed deposits will earn you compound interest, but may not be enough to beat inflation. On the other hand, equity mutual fund investments will have a better impact of compounding investments due to comparatively higher returns. This is why you should be prudent about the kind of investments that you make.

In general, the right investment instruments and longer time horizons can ensure that the power of compounding in investments is working in your favour. The sooner you start investing, the larger your corpus will be in the long-term.

How to Calculate Compound Interest?

The formula to calculate compound interest is as follows:

Compound interest = (P(1+r/n)^nt) – P

Where

P = Principal

r = Annual interest rate in decimal (i.e. 6% = 0.06)

n = number of times interest is applied in a year

t = number of years

Understanding Compound Interest with Examples

To get a better understanding of how compounding works, let’s look at some examples. 

For instance, Mr. A invests Rs. 50,000 as a lump sum for a return of 8%. This is how his money would compound:

As you can see, with an investment horizon of 30 years, Mr. A has been able to 10x his investment at a return of 8% p.a. But, on the other hand, the amount doesn’t grow 5x in 15 years; it only grows to 3.2x. That’s why it has been said that the real magic of compounding can be seen in the long term.

With a higher interest rate, the impact of compounding will be even more. Let’s assume Mr. A is able to get a return of 12% p.a. on his initial investment of Rs. 50,000. This is how his money would grow:

With a slightly higher rate of interest, Mr. A will be able to almost 30x his initial investment in 30 years. It is interesting to note that the interest rate has been increased from 8% to 12%, i.e. increment of 50%, but the corpus has been increased from 10x to 30 x, i.e. increment of 20x. This is the power of compounding.

Final Word

Compounding investments can work wonders to help you grow your wealth over time. Both the investment horizon and the interest rate play a pivotal role in helping your money grow. To make the most of compounding investments, try to invest your money over a longer time period and at best interest rate that you can get as per your time horizon and risk appetite.