You must have come across this term in your school mathematics where simple and compound interest was taught.
I wonder why they did not teach the actual practical utility and value of compounding in savings and investment.
But they do not!
Real life lessons are taught to you hard way. Make sure to understand the value of compounding so that you could save better, plan your investment and other things in a smarter way.
Simply put, compounding is a process where value of investment increases because interest on your principal investment also earn interest as time passes.
Let me elaborate.
Let us assume you invest 100000 rupees for one year and you earn 10% interest or gain on that.
After one year, the value of your savings [principal+interest earned] is Rs 110000
If you do not touch your saving or withdraw the interest earned, Rs 110000 becomes your principal for next period.
And you get Rs 11000, 1000 rupees more than what you earned in previous year.
This extra 1000 rupees are earned because Rs 10000 earned as interest in previous year also grew along the initial principal.
When this continues, more compounding periods result in a higher ending future value of the investment.
For example if we take the same principal into many years, without disturbing it, annual compounding would give is Rs 259,374.25 at 10 years and Rs 672,749.99 at 20 years.
Isn’t that wonderful!
Well! We have just started.
The snowball effect increases tremendously as the time grows. After period of 30 years, the amount would become 1,744,940.23.
Seventeen times richer you are now.
Thus, compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.
We considered annual compounding in our example. The compounding periods could be shorter like monthly, quarterly, semiannually or annually. With continuous compounding, any interest earned immediately begins earning interest on itself.
Shorter the compounding period, better the returns for any given period.
For example, in our example, if the compounding was after six months, after 10 years we would get 2653297.71 rupees instead of 259,374.25.
Albert Einstein is said to have called compound interest “the greatest mathematical discovery of all time
Thus power of compounding lies in transformation of your working money into a highly powerful income-generating tool.
Compounding is most powerful whenyou provide it time to work. In our example, the returns start becoming phenomenal as the term period increases.
The more time you give your investments, the more you are able to accelerate the income potential of your original investment.
What Does it Mean?
Time is biggest friend of your investments
Time is biggest friend of your investments. There is nothing like starting early. Early starters have the advantage of saving smaller to achieve more returns
Suppose that at age of Varun saved in his bank account Rs 15,000 at an interest rate of 5.5% which compounded annauly.
By the age of 50, Varun would have Rs 57,200.89 in his bank account.
Nikit is of the same age but he did not save any till he was 35. And then he saved Rs15,000 at the same interest rate of 5.5% compounded annually. At the age of 50 he would have Rs33,487.15 in his bank account.
Both invested the same amount of money. But Varun gave it more time to grow and earned a lot more.
Therefore, one should start young as for as saving is concerned.
But do not use that as excuse. Start now, whatever your age may be.
Another factor for compounding to work is that you must keep your hands off the principal and earned interest.
Compounding only works if you allow your investment to grow.
Initially, the results appear to be slow. But have patience.
Most of the magic of compounding comes late when it creates a snowball of money.
So, start early, and invest regularly.
Do you save regularly? Do not forget to share your saving habits in the comment section.