The Power of Compounding

25 Jan 2021  Read 2721 Views

Give me one candy you have and have it multiplied by 2,3,4 and so on. Sounds intriguing right? Now wouldn’t it be wonderful if the same can be done with your hard-earned money? In that case, all you have to do is use the powerful mantra of Compounding. 

Confused? Don’t worry; it’s no rocket science. In this article, we will assist you in finding out what Compounding is and how you can use it to your advantage.

What is Compounding? 

Compounding means, the increase in the value of the investment due to the interest earned on principal as well as on the accumulated interest. 

Compounding interest means, Interest on Interest. Every time you earn interest on principal, the interest is added back to the original amount, which becomes the principal for the next cycle.  

Have you ever noticed a snowball rolling down a mountain? You will see that it keeps on collecting additional snow and becomes bigger with every roll. Similarly, in Compounding, the interest is earned both on the principal and the interest that is previously accumulated. This happens continuously over the invested period, thus fetching your great returns at maturity. 

Let’s take a look at the example below: 

Two friends X and Y invest in a fund which is rendering about 10% as interest. However, while one invests on the fund that undergoes compounding growth, the other takes up the fund that pays normal or simple interest. After 10 years, the following will be their returns. 

Particulars 

Mr X

Mr Y

Sum invested

10 lakhs

10 lakhs 

Sum earned after 1 year

11,00,000

11,00,000

Sum earned after 2 years 

12,10,000

12,00,000

Sum earned after 10 years

25,93,742

20,00,000

From the table, you can clearly understand that over the years, compound interest might offer better fruits than its counterparts. This is because it generates interest upon both the invested principal amount of 10 lakhs and the generated interest of 1 lakhs, then on 2.1 lakh and the process continues till the end of the investing period. So after 10 years, you might have a huge sum in your hand, thanks to the power of Compounding.

There are a lot of online calculators which are available free of cost. For instance, you can use the Compound Interest Calculators itself to calculate the returns required. Type in the numbers and know the result in seconds!

But if you still intend to calculate the returns manually, then the below is the formula to calculate the same:

A = P (1 + [ r / n ]) ^ nt

P = principal

r = rate of interest

n = is the no. of Compounding

t = is the period the principal was invested for

3 Rules To Get the Best out of Compounding

As you have got a clear picture of the entire process of Compounding, it is essential you know how to use it to your advantage. So how exactly, do you do it? Let’s find out. 

3 rules you should follow in order rounding are as follows.

Understand compounding Smartly:

Though Compounding sounds like a very beneficial concept, it can easily backfire if you don’t utilize it properly. What one fails to understand is while Compounding helps your savings grow, it also assists your borrowing to accumulate in the same fashion. To be precise, just like your savings, the loan borrowed or your credit card borrowings can quickly turn into a huge sum using the concept of Compounding. 

Say you borrowed Rs.1000, as time goes the amount will also go on accumulating. This will force you to pay more than the expected amount. Hence, it is of crucial importance to keep your borrowings under control. To avoid the unnecessary mess, it is always advisable that you pay back as quickly as possible. 

The longer, the better:

Time always comes to your aid when you are investing. And Compounding, as we know, is no different. The longer the amount stays invested, the better will be your returns. People usually withdraw the amount when it starts generating income without understanding this concept. Even though you will be tempted to withdraw, it is always advisable to hold on to your investments for as long as possible. 

Apart from that, you must also contemplate on starting early. For instance, say you started investing at 20, and your friend started investing at 30. Here, you have a longer period to carry on with your investing as compared to your friend. 

Keep Track Of the Rates:

One of the most crucial components of Compounding is interest rates. The different investment avenues offer different interest rates. Choose one wisely and choose the one that best suits you. 

Have a quick look at the table below:

Different securities 

Interest rates 

Bank-based savings account

4 - 5%

Debt funds

7 - 8%

Equity-based mutual funds

12 - 13%

Shares 

15 - 16%

The above rates are what each of the investment avenues offers on an average. There is a high chance that your preferred investment portfolio is offering much more than this or lesser than this. 

However, the point is that you should keep a check on the rates and choose the one that best fits your goals and risk-taking ability. Even when you are borrowing, look for the interest rates. That way, you won’t end up paying more than what you actually have to pay. Also, don’t forget to take into account the tax while calculating the return. While all this is on one side, the number of times the sum gets compounded is something that should be examined as well. 

Having said that, while the above three rules are crucial to be checked off the checklist to make your principal grow exponentially, the discipline also happens to be another important deciding factor. A disciplined investor will know when to hold tact of their emotions. They will restrict unnecessary spending and will indulge in periodic savings. Thus, being disciplined plays a key role in Compounding, ultimately leading to wealth accumulation.  

Another element which, as an investor, you should have is patience. Be patient and relax while your money does the job for you.  

To Sum Up 

No matter how much you learn, it all comes down how you face the test. Similarly, irrespective of the knowledge you have gained here, it all boils down to how you utilize them effectively. 

So roll up your sleeves and get ready to do some wealth accumulation with all the tricks you learned!

Happier and wiser investing! 

About the Author: Varishika Dinesh | 136 Post(s)

Varishika is on the verge of successfully completing B.Com. Nothing excites her more than reading books and watching movies. Business, finance, economy? You have her attention.

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