When we talk about investing, very few people consider the importance of compounding. Let’s learn about the magic of compounding.
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, to earn more interest. 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?
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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. He or she 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 thought into 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 the warm-up. 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 figure this out, you can look at matching investment options.
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No matter how you go about your savings and investment business, keep compounding at the forefront of it all!