The awesome power of compounding!

By | October 19, 2010

Photo credits : Lisa Brewster

You will notice that the more you delay, the more you need to invest, hence it makes sense to consistently set aside about 10% of your monthly income for your retirement fund. This will mean your savings will increase correspondingly with your income, enabling you to grow your funds exponentially.

They say of trying to attain a weight loss goal, eat less and exercise more. Well, its no different when there is money involved. A parallel universal truth with regard to money is spend less, save more, for you to reach your ideal level of wealth. The earlier you start saving for your rainy day (read retirement) the richer you will be when it finally arrives.

In this context, you need not be a whiz in your attempt to make yourself financially secure for the future. You simply need to be consistent in saving a portion of your money and let it compound over time. The fascinating effect of compounding gathers up momentum over longer periods of time and becomes an avalanche of wealth.

How does compounding work?

When you save Rs.100 and get an annual interest of 10%, you will have Rs.110 at the end of one year. Due to compounding the next year you will get a 10% interest on Rs.110, which will then leave you with Rs.121. The next year, interest will be calculated on Rs.121 at 10% and so on. In time, these savings will grow exponentially.

There are certain number rules that have been evolved to figure out a quicker method for calculations, especially in finance. Rule 72, is one such quick method of calculating how much time it will take, for your investment to double.

So, if you invest Rs.100 with a compounding interest of 10% per annum, the rule of 72 gives 72/10 =7.2 years as the approximate time frame required for the investment to become Rs.200. If you equate the same to a larger amount of Rs.1L in approximately 7 years, it would grow to 2L. Remember you will be consistently saving up too, topping up existing funds, hence, if you are planning to retire 60 years from the time of the investment, it will approximately snowball to about 6 times from its original value. This is the avalanche effect of compound interest.

Fortune favours the early bird!

Compounding interest is like wine, yields better results when money is saved over longer durations. So, if you are planning to save crores for your retirement funds, then start as early as possible, with your first salary or at least by 25 years of age. So, when you retire at the age of 60, you will be sitting on a comfortable pile of money to lead the rest of your life in style.

If you set aside a sum of say Rs.5,000 every month from the age of 25, at a return interest rate of 10%, in 60 years you will have with you funds worth about a crore and more. However, if you start at 40 with the same amount and return rate of interest, the retirement fund will amount to only around 33 L. That is a huge difference, the 40 year old individual would need to invest several multiples of Rs.5000 to be able to catch up!

Here is a comparative chart of the approximate retirement funds an individual can lay claim to depending on the age at which he starts saving. Let us assume the individual plans to invest Rs.10,000, every year at a return interest rate of 10%. You will realize from the chart that starting early counts a lot!

Age at which investment begins Retirement fund
20 49L
25 30L
30 18L
35 11L
40 6L

You will notice from the above comparison, that even a matter of five years can make a huge dent on how much you retire with.

You could choose to start saving when you are much older and still meet the target retirement fund of 49L, saved by an individual who started investing from the age of 20. However, you will need to increase the amount of money you invest to make up for the lost time. This could be a strain on your budget, as you may have to set aside a significant amount of money to reach your goal. To illustrate, let’s see how much more you would need to invest and at what age, for you reach a target of 49L by the time you are 60 yrs old. Here is a comparison of the approximate increase in the amounts of money you need to shell out every year to reach your target.

Age at which investment begins Difference in funds invested
20 10,000
25 16,500
30 27,000
35 45,000
40 78,000

You will notice that the more you delay, the more you need to invest, hence it makes sense to consistently set aside about 10% of your monthly income for your retirement fund. This will mean your savings will increase correspondingly with your income, enabling you to grow your funds exponentially.

All you need to reap the advantage of compounding interest and save up a significant retirement fund is to invest time, consistency, patience, and savings to obtain a financially secure future, when you need it the most.

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5 thoughts on “The awesome power of compounding!

  1. Ash

    This was a very very good information. I would like to start one ASAP. Can one let me know in which type I could invest the money in compound interest. (like in which type of deposit should I invest). Also, will this come under I-T ?

  2. Tuwaram Dutta

    Article is helpful. Time is money.So,save as early as possible.

  3. Rajiv Sanyal

    pls advice as to how to create a corpus of Rs 200 lakh at the age of 60 yrs at the moment I am 42 , pls advice as to how to invest and what amount in ?

  4. ramesh

    is it advisable to preclose a homeloan if u hve the closing amt say 7 lakh just lying in fd in other bank . or to keep cash in hand and pey bthe emi which is never ending .

    1. p r varadarajan

      It depends on the interest you receive on FDs and Interest you pay on the Loan. One very important aspect is the components of your EMI and the tax exemption you are getting. Since you have pay tax on interest from FD or SB account. You need to calculate cash flows and taxes saved and the interest paid. Further if you are young you have many options of investment and earnings are available. As of today as the increase in FD interest is lagging the increase on loans better close the loan after neccessary calculation


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