Each time you come across investment theories, you would have come across the power of compounding. What exactly is that?
The formula for compound interest is A = P (1 + r/n) ^nt
A = future value of the principal amount, including interest
P = principal investment amount
r = the interest rate (annual)
n = number of times interest is compounded per year
t = duration (number of years)
Did that just bring back happy memories (or nightmares?!) of studying mathematics in your school days? 😉
The Power of Compounding
Like it or hate it, compounding plays a huge role in your investments whether you realise it or not. To refresh our memories,
Simple Interest v/s Compound Interest
Compounding means adding interest to the principal sum of a loan or deposit, so compound interest is like getting interest on interest, as opposed to simple interest, which is not added to the principal amount. Interest can be compounded daily, monthly, quarterly, half-yearly or annually.
If you invest Rs. 10,000 at 8% simple interest for 3 years, total interest payable after 3 years would be Rs. 2,400. The same amount if compounded annually would return Rs. 2,597.12.
You would have come across numerous examples of Person A investing some amount every month at age 25 and Person B investing a higher amount each month at age 35, till both retire at 60, and Person A ending up with a much larger corpus on retirement even though Person B invested more money.
Well, the magic here is the power of compounding. Person A was invested for 420 months, Person B was invested for 300 months. The difference of 120 months enabled that interest to add to the principal amount for a longer period, allowing it to grow more in the case of Person A.
What works for compound interest?
a) The overall period, and
b) how often the interest is compounded
(in the first example, the interest payable would have been Rs 2,702.37 if the interest was compounded monthly). When the compounding interval is shorter, the interest gets reinvested that much more often, adding to the overall corpus.
It doesn’t matter if you prefer investing in a mutual fund via the SIP route or making contributions to your PPF account, or even how much you’re investing each month. It can even be 5-10% of your monthly salary. Just keep doing so regularly and avoid withdrawals as much as possible.
a) Invest as early as possible (it’s never too late to start)
b) Owe as little as possible
c) Save before you spend
d) Stay invested
For a quick ballpark figure when calculating returns related to compound interest, there’s an old Rule of 72 that works well for interest rates between 6% to 10%, and can be tweaked for lower/higher interest rates. To know how much time it takes for your money to double at say, 8% interest, divide it by 72, which is ~ 9 years. Likewise if you wish to know at what interest rate your money will double in say, 6 years, the answer is ~ 12%