In the vast and exciting world of finance, the concept of compounding echoes throughout the domain, its power often underappreciated. It is one of the hidden gems of finance that everyone who ventures into finance must know about. To put it into perspective, Alber Einstein actually claimed that the concept of compounding was the eighth wonder of the world. Imagine investing a certain sum of money and two years later it doubles itself in value. How? You ask. Through the use of compounding .
When you decide to use compounding, you are essentially reinvesting the money that you have earned and in subsequent terms, converting your investments into a flowing source of income that is self sustaining and generating more money. In short, a smart decision from your end and your money starts earning for itself. So now that we have seen the different praises and wonders of compounding, what is compounding? Let’s find out.
Before we get to compounding there are three terms that must be known to understand compounding:
Principal- Principal is the sum of money that you are investing. It is the money on which your interest will be generated. In compounding, this amount changes at fixed time periods according to the interest you earn in each time period. For example, if a person invests with a sum of 1000 Rupees, then that sum becomes their Principal.
Interest Rate- It is the percentage amount earned on the invested Principal per period. It is a certain percentage number, ranging anywhere from single digit numbers like 5 or 6% to double digits like 11 or 12%. The interest rate is a crucial parameter to be understood as your returns depend on the interest rate. The higher the interest rate, the higher the returns and vice versa.
Time Period- The time period is the duration of time for which your money is to accrue the interest. The most common time periods are annual or semi annual time periods. Since compounding is a long term investment concept, time periods are usually lengthy.
Compounding is a powerful tool that acts on the concept of a multiplier. In financial terms, it means that through compounding, you earn interest not only on your principal, but also on the interest. So, in a nutshell, compounding is earning interest on your interest.
How it works is when you invest a certain sum of money, it earns some interest on it via a fixed interest rate for a fixed time period. When you add compounding to this, your interest is added to your original sum of money and then you earn an interest on that new sum of money!
To show you how compounding works, here is a small example:
If you invest a Principal of Rs 100 at 10% interest rate Compounded annually then,
In 10 Years you will have Rs 259
In 20 Years you will have Rs 673
In 30 Years you will have Rs 1745
In 40 Years you will have Rs 4526
In 50 Years you will have Rs 11739
Now that is just for Rs 100. Imagine what you can earn when you invest more instead of putting all your money in a piggy bank.
A good idea would be to use smaller terms for your investment so that your money grows more by being reinvested more often. The more often you earn interest, the more often you can reinvest your money.
Compounding as stated above is a long term strategy and that is why we encourage everyone to start early and get a comparative advantage.
No amount is too small and no one needs to invest huge sums to get huge returns, the power of compounding takes care of that for you!
Getting a head start with a small capital which through the power of compounding you can grow into something bigger is the best decision one can take right now.
Before you learn the formula for compounding, you need to learn the formula for what you need to start compounding
Steady Savings + Patience = Big Future Rewards
With patience and steady investments, everyone can grow their wealth by leaps and bounds over a course of time. The only barrier is to get started. Once you understand the power of compounding, you will see how the longer you wait, the higher returns you get.