In this blog, we’ll discuss why the power of compounding is important for your financial life and how it can work in your favor to grow your wealth. Compound interest can transform our financial lives in extraordinary ways.
“Compound interest is considered to be the eighth wonder of the world. He who understands it earns it, and he who doesn’t pays for it.” – Albert Einstein
List of contents
- What is compound interest?
- Why is compound interest more effective than simple interest?
- Why compounding is important
- Benefits of compounding
- How compound interest works
- Parameters that affect compound interest
- Conclusion
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What is compound interest?
In a simple word, compound interest is “interest on interest.” This is the idea that the interest you earn on your money can also generate its own interest.
Compound interest is a powerful financial concept. It is a form of interest in which the interest earned on a sum of money is added to the principal, and then the new total amount is used to calculate the interest for the next period. This cycle of interest calculation and addition continues over time, leading to exponential growth in the original principal or amount.
Why is compound interest more effective than simple interest?
Simple interest is calculated on the original amount invested, while compound interest is calculated on both the original amount and the accumulated interest. As a result, the amount of interest earned on compound interest is greater than simple interest.
Ex.: Let P = Rs 10,000, and R = 10%.
| Time | SI | CI | Difference of CI and SI | Amount invested in SI | Amount invested in CI |
|---|---|---|---|---|---|
| After 1 year | 1000 | 1000 | 0 | 11000 | 11000 |
| After 2 years | 1000 | 1100 | 100 | 12000 | 12100 |
| After 3 years | 1000 | 1210 | 110 | 13000 | 13310 |
Above table clearly shows that investing our money in compound interest over simple interest gives us a higher return.
Why compounding is important
Compounding is important because it allows your money to grow faster over time. When you invest your money, the interest or returns you earn on your investment can be reinvested and added to your principal amount. This means that your investment earns interest not only on the initial principal amount but also on the interest that has accumulated over time. As a result, the interest earned on the investment grows exponentially rather than linearly.
The power of compounding comes from the fact that the interest earned on your investment is reinvested and continues to earn interest, creating a snowball effect. This effect can lead to significant and massive growth in the value of your investment over time, especially if you have a long-term investment horizon.
Benefits of compounding
There are several benefits to compounding, including
- Increased Returns: Compound interest provides a higher return on your investment compared to simple interest, resulting in significantly higher returns than simple interest.
- Faster Wealth Accumulation: By compounding your investments over a longer period, you can maximize your investment returns and achieve your financial goals sooner.
- Reduces the Need for Large Contributions: By compounding your investments over time, you can achieve your financial goals with smaller contributions, rather than having to make large contributions upfront.
- Flexibility: Compounding also provides you with investment flexibility. By reinvesting your returns, you can choose to increase the size of your investment, maintain your investment, or withdraw your returns as income.
How compound interest works
The compound interest formula for calculating CI
A = P(1 + r/n)^nt
Where, P = Principal i.e. money invested , A = amount at the end of the investment period
r = interest rate , n = number of compounding periods per year, t = time
To better understand compound interest, let’s consider an example. Suppose you invest Rs 10,000 at a 5% annual interest rate for 5 years, with the interest compounded annually. After the first year, you would earn Rs 500 in interest, bringing your total balance to Rs 10,500. In the second year, the interest would be calculated based on the new balance of Rs 10500 rather than the original principal of Rs 10000, and you would earn Rs 525 interest in the second year. This process is repeated each year, with a final balance of Rs 12763 after 5 years.
Let principal = Rs 10,000 and R% in p.a.
| Time | Rate 5% | Rate 10% | Rate 15% |
|---|---|---|---|
| Amount after 5 years | 12763 | 16105. | 20114 |
| Amount after 10 years | 16289 | 25937 | 40456 |
| Amount after 15 years | 20789 | 41772 | 81371 |
| Amount after 20 years | 26533 | 67275 | 163665 |
This table clearly shows power of compounding that the rate of interest and time directly affect the compound interest.
Parameters that affect compound interest
Compounding has two important factors: interest rate and time (frequency of compounding).
- Interest Rate: The interest rate you earn on your investment, i.e., the returns you earn It gives compound interest its multiplication nature. Earnings are generated both from the principal investment and from the subsequent interest earned.
- Time duration: The longer your money can remain uninterrupted, the more your wealth can grow with the help of compounding. As a result, even small contributions made regularly can make a big difference over time.
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Conclusion
In a simple word, compound interest is “interest on interest.” The power of compounding is important for anyone looking to grow their wealth over time. By investing wisely and as early as possible, you can achieve exponential growth and increase the value of your investment in the long run.
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