Biggest Secret Revealed: How Compounding Helps You Make Money

By Lehar Maan | September 20, 2017

How Compounding Helps You Save Money

When people talk about investing, they speak at length about the importance of it and why you should start early. But more often than not, they forget to share an important tip on how to go about it smartly. Is there a secret method? Yes! More than one, actually. In this article, we will be talking about one of them – compounding. Yeah, compounding – a simple trick that will help you get the most out of your investments.

Compounding – What does it mean?

Well, to put it plainly, compounding is reinvesting the interest earned on your investments, along with the principal amount (very important), to earn more interest bucks. Getting the drift? Ok, let’s break it down for you with an example.

To understand compounding, you must understand the difference between simple interest and compound interest.

Simple Interest

Let’s say you invest Rs. 50,000 at an interest rate of 8% p.a. Following the simple interest calculation, you’ll have Rs. 12,000 in your kitty as interest money at the end of 3 years. How did we arrive at this figure? Let’s look at the table below:

No of years Principal Amount Interest Rate Interest Earned
1st year Rs 50,000 8% Rs. 4,000
2nd Year Rs 50,000 8% Rs. 4,000
3rd year Rs 50,000 8% Rs. 4,000
TOTAL Rs. 12,000

Simple interest is interest earned only on the principal amount.

Compound Interest

Now let’s rework the same example following the compound interest calculation.

No of years Principal Amount Interest Rate Interest Earned
1st year Rs 50,000 8% Rs. 4,000
2nd Year Rs 54,000 8% Rs. 4,320
3rd year Rs 58,320 8% Rs. 4,665.6
TOTAL Rs. 12,985.6

If you notice, interest earned in one year is added to the principal amount for the subsequent year before it is reinvested and so on. This increases your principal amount periodically, thus allowing you to get the most out of your investment.

Isn’t the difference clear now?

Additional Reading: Financial Mistakes You Will Regret At Age 50

Still not convinced?

When you begin investing, you might not be too thrilled seeing only a small difference in returns from the simple interest and compound interest methods. You might even be tempted to use the interest for discretionary spending while reinvesting the principal. But don’t be hasty! The true power of compounding will be known with time. As you keep fattening the principal amount with the addition of interest, your returns in the form of interest will also get bigger and fatter.

Consider this, you and your friend start your investment journey at the same time and with the same amount. Let’s say for the next 10 years you follow the simple interest method while your wiser friend follows the compound interest method. At the end of the tenure, your friend’s account will be much more pleasing than yours. S/he will be better equipped to make investments like buying a house.

So don’t ignore compounding when investing your money.

Is there a trick to get the maximum benefits from compounding?

We thought you wouldn’t ask!  Yes, there is! Just compounding without putting any mind to it will not give you the best returns. The frequency and tenure matters. The returns are best when you compound for short durations, but don’t disturb the cycle of investment for a long time. You can compound yearly, half-yearly, quarterly, monthly. The shorter the tenure, higher the returns. But this doesn’t mean you stop compounding after a few reinvestments. Let this cycle go on for as long as you can. The results will speak for themselves.

Sounds good! So when should I start?

The earlier, the better. Don’t leave savings and investments to tomorrow. Start today. You are losing out with each passing day. Are you among the smarter ones who started saving early? Time to upgrade. Savings is just for warm-ups. But don’t ignore it completely. Try Mutual Funds or stocks. If you are unsure of what to do next then begin by charting out your short-term and long-term financial goals. Once you have this straight, you can look at matching investment options.

Additional Reading: Your First Steps To Investing In The Stock Market

No matter how you go about your savings and investment business, keep compounding at the forefront of it all!

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Category: Equity investing Investments
Lehar Maan

About Lehar Maan

When not writing articles for the BankBazaar blog Lehar spends her time buried inside books by Dostoyevsky, Oscar Wilde and Salman Rushdie. Her life goals are to turn all long weekends into fulfilling holidays and convert her prolonged sleep hours into more productive time. She also likes all things watercolour, cupcakes and Star Wars.

2 thoughts on “Biggest Secret Revealed: How Compounding Helps You Make Money

  1. M D Modi

    My Bank (PNB) has evaluated loan and categorized it in NPA. It is about 8 crores Rupees. They have also freezed my account. The loan was taken on stocks of factory . The Bank has taken the view that it is old stock ; that it is overvalued. Bank has taken my factory land and building, my residential building and factory’s guest house as collatoral securities. The current market value of these properties are 11, 6, and 1 crore respectively. The Bank informed me that they would auction them. Can I request Bank to
    evaluate the current price of theses immovable properties and provide me loan to be used in repayment of factory loans, now as NPA. Further can value of NPA be negotiated to a lower amount, say to 7 crores ? I propose to pay in one go if I can get loan on properties mentioned above. Then I would not need loan on stocks of factory which is called cash credit. The loan can be given to me by PNB Housing Bank Ltd., a sister unit of PNB. Please send me your advice, I will be grateful.

    Reply
    1. Team BankBazaar

      Hi M D Modi,

      Negotiations with your bank are possible. Banks usually agree to one-time settlements if you are able to prove that you are unable to repay the loan due to financial issues. Due to the specific nature of your question, we’d recommend that you get legal advice on this matter.

      Cheers, Team BankBazaar

      Reply

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