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Understand The Power Of Compounding

compound-interest

Having a basic financial understanding is very important to achieve our financial goals in life. Although there are so many other things in finance we need to learn but compounding is one of the most important subjects one should be aware of.

Compound interest is  reinvesting the earned interest back into the principal to multiply your earning. This results in an exponential growth over the time.

The power of compounding is massive and if you spend some time understanding it, you will be able to use it for your benefit and grow your wealth exponentially. Compounding teaches all of us that small amount of savings over a long period of time can lead to a huge corpus.

Example of Compounding

Let’s look at an example to understand how compounding can help you multiply your returns   when compared to simple interest. Let’s say there are two people John and Mike who have invested Rs 1000 each at an interest rate of 10% per annum.

Every year they will be earning 100 rupees of interest. However, John is withdrawing this hundred rupees every year,  whereas Mike understands the power of compounding and decides to reinvest his earned interest every year in the same investment plan.

compound interest-1

As we can see after the period of 10 years John would have earned a total of 1000 rupees of interest on his invested amount. Whereas Mike would have made Rs 1594 which is much more than John.

Importance of Time in Compounding

Time acts as a fuel in increasing the power of compounding to the next level. Longer the duration for the investment larger the returns you can expect. You can see in the chart below how massive return has been given by compounding interest when left over a period of 40 years.

compound interest-2

How To Harness The Power Of Compounding?

In order to multiply your income using  the method of compounding  you need to make sure that you do not withdraw your money from your investment fund unless it’s really necessary, the best thing will be to let it be reinvested and pile up into huge sum after a period of time

Another key factor is to start early in your life. Because the earlier you start, your investments will get more time to turn into a huge fund.

Power of Compounding Can Work Against You

The power of compounding also works against you, whenever you take a loan you are not only paying interest over the principle but also over the interest amount too. So it works like a double-­edged sword in this case.

So rather than taking a loan and paying a huge amount of interest it would be better to start with an investment plan earlier in life and use the corpus accumulated to meet your financial goals.

Conclusion

Now that you understand the power of compounding,   it is time for you to find an experienced financial planner who will help you allocate your funds in the right assets, to accelerate your income to the next level.

Moiz Choolawala
Moiz Choolawala
Moiz Choolawala is the founder of Plansmart and a SEBI Registered Investment Adviser. An MBA in Finance and Marketing Moiz is an experienced investment adviser and blogs about investments, personal finance, insurance planning and tax planning.

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