Imagine you have 1 rupee and you double this money every day for the next 30 days. Now, how much amount would you end up with at the end of that month?
Day 1 - Rs 1
Day 2 - Rs 2
Day 3 - Rs 4
Day 4 - Rs 8
And you end up with
Day 30 - Rs 53 crores
Something around Rs. 53 crores from Rupee 1 in just one month!
This is the best example of what is the power of compounding interest.
Your money is built-up over time because not only was your principle amount collecting interest - but all the capital that you gained as interest also began to gain interest and so your money compounded with the duration of a long run.
That's how we come up with the term 'compound interest' and that's how you can become rich by saving money over a longer interval of time.
1 What exactly is compounding of interest?
As per the definition of Wikipedia,
'Compound interest is the addition of interest to the principal amount of a loan or deposit, or in other words, interest on interest. It is a contrast to simple interest, where interest is not added to the principal amount, so there is no compounding'
2 MOST IMPORTANT COMPOUND INTEREST PRINCIPLES TO KEEP IN MIND
First Principle: There is no such thing as Simple Interest
According to Pauline Graham,
'In compound interest part of the activity of growing is the adding of the growing'
In other words, compounding relates to the re-investing of the interest with the original amount at the same rate of return to consistently build-up the principal amount over time.
You might have come across the various advertisements where borrowers are being promised the interest rates that are much higher than the current prevailing rate of returns. We are often misled into believing that it is the simple interest that we will be earning during the period of investment. But which in reality is 'the interest' that is being compounded each year. Which leads us to the first principle - 'there is no such thing as simple interest'
It would prove to be a great deal to enhance your financial grounds if you used this principle when you make investments.
Second Principle: Even the smallest percentage of rate ratio makes a BIG IMPACT over longer period of time
Usually, we don't much care for whether we are getting a rate of interests as 10% or 11%. But if we did, we could make a huge enhancement to our wealth year after year.
The primary benefit of compounding comes from the fact that the interest you gained keeps growing your principal amount rendering higher returns each year. Investing in the same return rate for a longer investment period can grow your principal amount symmetrically.
If you are young then time is on your side now, so start putting-up your wealth by harvesting the 'miracle' of compounding interest to work for you. Because if 'compound interest' is the key to your wealth, then 'time' is the essence that turns this key to unlock the door to your future gains.
For the power of compound interest to work its wonders, you need to focus on these three important components:
1. How much amount you have invested
If you are disciplined and conservative about the amount you want to invest, you can save upto 10% of your income and put-up that percentage in the market.
2. How many years you want to stay invested
Don't consider this point as disputable, but rather as a mathematical reasoning. Compound interest works miracle after about 20 to 30 years. That's why it is so important and why you would have a greater advantage- if you start young.
Also read: The art of investing in long-term
3. What return you will get for that investment
The money that you are investing today may have an uncertain impact or offer low yields at a totally uncertain point in your future. You may not get 20% returns on your stock in your investment period. But if you learn how to invest in debts, stocks, and real estate’s - you can expect to earn 21% returns from that.
To learn more about the returns on investment read How to ensure that the returns on your investments for your retirement beat inflation.
THE IMPACT OF THE POWER OF COMPOUND INTEREST
Let us assume that you started investing at a young age of 25 years, putting aside Rs. 200 per month in a tax-deferred investment scheme at the return rate of 9%. At the same time, your friend who is 45 years of age starts investing in the same scheme. But he is investing an amount of Rs 400, which is double your amount.
At the age of 65, both of you would have invested Rs. 96,000. However, your total investment income would have grown to somewhere around Rs. 8 lakhs while your friend's investment would have been raised to Rs. 2 lakhs.
Here your investment has increased exponentially than your friend's, even though both of you invested the same amount - because of that early start. You had the upper hand of that extra 20 years of compounding over your friend's.
This perfectly explains how through the power of compounding even a small amount can grow into a substantial sum over a long duration of time.
We know that at this moment you may be wondering,
“If it’s so easy to amass such a fortune, then why isn’t everyone rich?”
The answer is:
No one does what they are suggested to do. No one puts aside the consistent part of their income for investment at the early age as advised. Nor do they stay invested in well balanced conservative stocks and other such portfolios. But by contrast, the people who do it 'DO' become wealthy over time. Maintaining discipline, patience, and disposition through the entire journey is what will actually make you rich.
In long-term compounding investments, the principal sum starts generating higher amounts of geometric proportions after some years. It is literally a 'waste of money' to let your wealth dwell in low-income investments for shorter periods of time. Although different returns are retained for short term investments which may help you to build-up your wealth level, the result is not that earth-shattering. Compounding interest on long-term investments can help you to grow your initial investment at an exponential rate.
Don't know where to start?
Afinoz, an online financial marketplace offering investment products will provide you with the real-time SIP investment advice and services. It will also help you as a mutual fund advisor to get you the best performing Mutual Fund - SIPs according to your risk appetite. You can contact us for any investment advice at +91 - 8750959730 or mail us at firstname.lastname@example.org.