What is compounding?
Compounding refers to the process of generating income by reinvesting the earnings from an investment. Earnings can be in the form of interest or capital gains. Your earnings are added to the previous amount, which then becomes your principal to calculate the interest for the next compounding period.
Banks or financial institutions use compounding periods to calculate compound interest. It can be daily, weekly, monthly, quarterly, or yearly.
What is compound interest?
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.Albert Einstein
Compound interest is the interest calculated on the principal amount as well as the accumulated interest over the previous period. It is basically the interest which you earn on interest.
Compound interest formula:
Compound Interest= Amount – Principal
For calculating amount:
A=P (1 + r/n)^(nt)
where A=Amount, P= Initial Principal Amount, r= rate of interest, n=number of times interest applied per time period, and t=number of time periods.
How does compounding work?
Compounding allows your investment to grow exponentially. But how?
Let’s take a look at this example to understand how compounding works and how to use the power of compounding:
Suppose you invest Rs 1,00,000 on an asset with an interest rate of 10% per annum. After one year the principal amount will become Rs 1,10,000 (Rs 1,00,000 – principal amount and Rs 10,000- Interest earned) and interest for the next year will be calculated on this amount.
The following table will help you understand it more clearly:
|Years||Principal Amount (Rs)||Interest earned (Rs)|
In this way, after 10 years the total interest earned will be Rs 159374 and the value of your investment will be Rs 259374.
If you keep reinvesting your earnings in the same way your investment of Rs 1,00,000 will grow tremendously.
What happens if you don’t reinvest your earnings?
Compounding works on ‘reinvesting your earnings’ from an investment which leads to increase in the investment value. But if you don’t reinvest your earnings your investment value will be the same even after many years.
Let’s understand this through an example:
Case-1: Reinvesting your earnings
|Years||Principal Amount||Interest @10% p.a.|
Case-2: Keeping your earnings aside
|Years||Principal Amount||Interest @10% p.a.|
Let’s now take a look at total interest earned and the value of the investment after 15 years in both cases:
|Investment options |
|Total Interest earned @10% p.a. |
|Total value of investment after 15 years|
|Reinvesting your earnings||317724.8169||417724.8169|
|Keeping your earnings aside||150000||250000|
If you utilize the power of compounding, after 15 years the total interest earned on your investment will be 3 times more than your original investment.
Isn’t it amazing? Well, that’s the power of compounding.
On the other hand, if you don’t reinvest your earnings you will not get much benefit out of your original investment.
Additional tip: If you keep increasing your principal amount by depositing sums of money every year apart from adding the interest earned, your investment will grow into a huge corpus after a decade or so.
How to take the most advantage of the power of compounding?
- Start early: It is advised to start investing early to take the most advantage of compounding. But if you haven’t started it yet, you can start now as well. First, specify your financial goals and identify the investment options that suit your goals. Select the best alternative for investing your money to ensure the fulfillment of your future financial goals.
- Be patient: Good things take time but happen for sure. The same goes with compounding too. You have to be patient to get good results on your investment. To take the most advantage of compounding, it is advised to invest for the long term and be patient.
- Be disciplined: Discipline is the most important attribute of your investment journey. Don’t miss your SIP payments and try to be regular in your investments to accomplish all your financial goals.
- Raise your investment value: ‘Money makes money.’ To raise your investment value, try to increase your principal amount by investing more money. Ultimately the power of compounding will grow your money exponentially.
- Spend Wisely: One more way to increase the value of your investments is to manage your expenses and save more. If you will save more money, ultimately you can invest more. Create a budget to identify your sources of income and spending habits. Cut your unnecessary expenses and invest that amount because the more you invest, the greater will your returns be.
Beware of Negative compounding
Negative compounding means the compounding which does not provide any returns and also does not increase the value of your investment. In such cases, the amount of the returns are even less than the capital invested. It is important to overcome the negative compounding effect to save your money as well as your time. You should analyze all the investment options and select the most appropriate ones. Additionally, you should keep monitoring all your investments to be aware of their performance. Another important thing is to take off your money from those investments which do not provide any positive returns and also don’t show growth in the future.
I hope this article helped you to understand the basics of compounding and compound interest.
You can benefit a lot from the power of compounding if you use it wisely. You don’t need to have a lot of financial knowledge for this. Just a little bit of research and constant watch on your investments would definitely work for you.