The Buyt Desk
Do you know the eighth wonder of the world? To emphasize the power of compounding, Einstein called it the eighth wonder of the world. Compound interest on investments is at the core of wealth creation. The concept of compounding allows your money to grow exponentially thereby creating a corpus for your future endeavors.
Compounding means that you earn interest on interest. Though you did not add new funds to the saving account, yet the capital appreciates by the power of compounding. For instance, you deposited Rs.10, 000 in the bank in 2019 at the rate of interest of 5% per annum. At the beginning of 2020, the amount in the account will be Rs.10, 500. In 2020, the yearly interest will also apply to the previous year’s interest (Rs.500). At the beginning of 2021, the account will have Rs.11, 025. This is the beauty of compounding that it makes your money grow.
Rule of 72
During childhood, you would have definitely solved mathematics problems related to compound interest. You do not need to be a mathematician to understand and apply the compound interest calculations to your finances in daily life. Simply understand the Rule of 72. When you divide the number 72 with the expected compound rate of return, the resultant number is the number of years for the capital to double at that rate. You can adopt this rule for different calculations. Let us try to understand the impact of inflation. Suppose the yearly rate of inflation is 5%. The result is approximately 14 on dividing 72 by 5. This means if you have Rs.1 lakh today then after 14 years, its value will be diminished by 50% to Rs.50, 000 due to inflation.
Factors that affect the power of compounding
Compounding creates wealth. But are you extracting the maximum benefit from it or not? There are certain factors, which determine whether the potential of compounding is being utilized fully for wealth generation or not.
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Rate of return: Investments have a different rate of interest/ rate of return. Higher the rate, higher the return, and greater the potential of wealth creation. To receive more benefit, invest funds at a higher rate. Nonetheless, investment decisions are not straightforward and do your due diligence before investing.
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Frequency of Compounding: Shorter the interval of compounding, the greater the potential to create wealth. The rate of interest is higher when interest is compounded daily in comparison to longer duration like quarterly or yearly.
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Time of investment: The earlier you start to invest, the greater amount you earn. The longer you will stay invested, the greater number of times compounding will apply, and you will earn more.
Mutual funds and the power of compounding
Many investments offer the advantage of compound interest. For example, mutual funds, PPF, FD, saving account, etc. Certain small saving schemes like Senior Citizen Saving Scheme do not have the advantage of compounding. In such schemes, the fixed rate of interest is paid as a regular income and is not compounded. Mutual funds give two main investment options: dividend and growth. The growth option in mutual funds takes the power of compounding to the next level. This is because the interest earned on the interest is also reinvested in the mutual fund along with the capital. At the end of the investment tenure (not below 5 years), a mutual fund will create a higher corpus than other investments by leveraging the power of compounding to the zenith. However, do not invest by considering only a single determinant. It is best to consult a certified financial advisor to invest your money.
