What is the power of Compounding Interest?

The power of compounding is the most powerful tool in the world. That is to say, your money works hard to make more money for you and uses the ‘time’ to multiply your money. Further, it does not need any action from your side. However, the power of compounding is a double-edged sword. To clarify, it can work in your favor or against you. Thus, a financially smart person, who understands the power of compounding and implements it, can bring the power of compounding to his side and become rich. At the same time, it can cause devastation for a person who doesn’t know how to use it. That’s why Albert Einstein once said, “The power of compounding is the 8th wonder of the world and he who understands it… earns it, and he who doesn’t… pays it.”

You have read simple interest and compound interest in your school days. So, what is unique about it? To answer this, I can say that a school can make you knowledgeable, but not wise. It can feed your brain with data, but may not teach you how to interpret it. Schools teach us about freedom, but not how to get it. Thus, the subjects taught at school has become a liability, not an asset. Our schools can make our kids financially literate and teach them about saving, investing, budgeting, debt, insurance, compounding power of money, and more. 

Further, with the right attitude and mindset to make money and help others, our children may not experience financial nightmares and bankruptcies. That is to say; they can live a healthy, wealthy, happy, and fruitful life.

What is the power of compounding?

Let’s start with ‘interest.’ Interest is the cost of borrowing money. However, there are two types of ‘interest’ – ‘simple interest’ and ‘compound interest.’ For example, in simple interest, a fixed rate of interest is paid on the principal amount of borrowed money. 

In compound interest, we pay interest on interest also.

Let’s understand it with examples.

Simple Interest example

Have a look at the table below, please. Meanwhile, I have applied a simple interest rate of 8%.

YearPrinciple Amount (Rs)Interest Earned (Rs)Year-End Balance (Rs)
1100.008.00108.00
20.008.00116.00
30.008.00124.00
40.008.00132.00
50.008.00140.00
60.008.00148.00
70.008.00156.00
80.008.00164.00
90.008.00172.00
100.008.00180.00
Simple Interest Calculation Sheet
TABLE NO – 1

In the above table, Rs 100 earns simple interest of 8% and gets added to the year-end balance. Therefore, as you can observe, only the principal amount is gaining interest. Thus, at the end of the term (10 Years), the accumulated total amount becomes Rs 180.

Simple Interest Calculation Sheet

Let’s see how the compound interest works.

Compound Interest example

Look at the table below, where I have applied a compound interest rate of 8%.

YearPrinciple Amount (Rs)Interest Earned (Rs)Year-End Balance (Rs)
1100.008.00108.00
20.008.64116.64
30.009.33125.97
40.0010.08136.05
50.0010.88146.93
60.0011.75158.69
70.0012.70171.38
80.0013.71185.09
90.0014.81199.90
100.0015.99215.89
Compound Interest Calculation Sheet
TABLE NO – 2

In the above table, we calculated a compound interest of 8% per annum, and that turned Rs 100 to Rs 215.89 over ten years. However, in the simple interest calculation, it was only Rs 180. That means the compound interest generated 19.94% more interest than the simple interest, and that’s around 20% more in just ten years. With time, this percentage will also grow substantially, and the gap will be more extensive. 

Compound Interest Rate Calculation Sheet

Let’s compare the growth rate of both of these interest rates with the help of a table.

Simple Interest Vs Compound Interest
CHART -1

As you can observe, the lines are almost parallel in the initial years, but grow wider with each passage of time. It is the magic of the power of compounding. However, you can prepare for 20 years, 30 years, 40 years, or even more and see the magic.

Four key elements that determine the power of compounding

Do you know what the four key elements that determine the power of compounding are? Let’s have a look at each of them.

1The Rate of Interest you get

It is an essential factor and plays an important role. For example, I assume you deposited Rs 1,00,000 in a bank fixed deposit at a rate of 6% per annum and your friend in a mutual fund and got 12% per annum. You can call it CAGR (Compound Annual Growth Rate) also. Now, see the magic of the rate of interest.

Disclaimer – I don’t endorse any mutual fund products. It is just for the sake of an example. Mutual funds are subject to market risksPlease read the offer documents carefully before investing. 

You Your friend
Rate of Return6%12%
10 years1,79,0003,10,000
20 Years3,20,0009,64,000
30 Years5,74,00029,95,000
40 Years10,28,00093,05,000
50 Years18,42,0002,89,00,000
Role of the Rate of Interest in the power of compounding
TABLE – 3

The returns are nowhere closer to each other. Your initial amount of Rs one lakh will turn into Rs 18,42,000 over 50 years. On the other hand, your friend’s amount will be Rs 2,89,00,000. It is incomparable.

Warning – Don’t get distracted by high return promises. You have to remember that high return comes with high risk. But, taking a high risk may not produce a high yield.

2The time you give to your investment

Time is the most powerful feature in the power of compounding. Thus, the longer your money stays in the investment, the more return it generates.

Let’s have a look at the table below. For instance, there are four friends A, B, C, and D, and each of them invested Rs one lakh for different terms and has got a decent annualized return of 10 percent, and the result is in front of you.

YearABCD
10 years2,59,0002,59,0002,59,0002,59,000
20 Years6,72,0006,72,0006,72,0006,72,000
30 Years17,44,00017,44,00017,44,000
40 Years45,25,00045,25,000
50 Years1,17,39,000
Time Value of Money – The power of Compounding
TABLE NO – 4

The same amount, the same interest rate but fantastic returns with time. For example, staying just another ten years results with incredible performances. ‘A’ stayed for only 20 years and got Rs 6.7 lakh whereas ‘D’ stayed for 50 years and generated Rs 1.17 Crores. Isn’t it amazing?

A common question

You can ask me, “Why are you stretching the period to 50 years? Can anyone stay invested for 50 years? That’s impossible and illogical also. That is to say; we are earning money to enjoy the fruit of it. For example, someone gets a job at the age of 25-30 and gets retirement at the age of 60. Therefore, a period of 30-35 years is imaginable; not more than that“.

I agree with your point to some point, but not entirely. Remember, it is a universal rule. Therefore, the law applies to your child also. You might have reached a threshold where a few years are left to retire. However, imagine how many years are left with your child to retire when he or she is a newborn baby, a toddler, or a primary school-going child. That is to say, you can think about his or her retirement as a responsible parent. For instance, just Rs 1,00,000 can make your child a millionaire at the age of 60. Thus, to put it in the figure, Rs one lakh translates to Rs 1,17,39,000 grown at a rate of 10 percent per annum.

However, the journeys from one lakh rupees to one crore rupees is simple. You need to stop some of those expensive birthday celebrations or those expenses that you can control or minimize at the beginning stage of your child and put that money in an index fund and stay invested for the next 50 years. Therefore, it is advisable for those parents who say that they have no money to invest. Subsequently, you can pause and think about the money you have spent or going to pay to celebrate your child’s birthday.

3The Compounding frequency of your investment

A Compounding frequency means the intervals when you receive interest, or it gets added to your principal. For example, a quarterly compounding interval means interest is paid quarterly or is added to the principal amount. Thus, the more frequent compound interval means more interest.

For example, four friends named A, B, C, and D have deposited Rs 1,00,000 and got an interest rate of 10%. ‘A’ receives interest quarterly – ‘B’ on a half-yearly basis – ‘C’ on an annual basis – and ‘D’ gets a simple interest. Then, let’s have a look at what they will receive at different periods.

ABCD
Compounding IntervalQuaterlyHalf-YearlyAnnuallySimple Interest
10 years2,68,0002,65,0002,59,0001,99,000
20 years7,20,0007,03,0006,72,0002,99,000
30 years19,35,00018,67,00017,44,0003,99,000
40 years51,97,00049,56,00045,25,0004,99,000
Compounding Interval Comparison
TABLE NO 5

There are a few investment options (e.g., Bank FD STDR) that compound your money quarterly. However, most products compound every year. Therefore, it is always better to find a product that compounds your money in the short term.

4Tax on your investment

A lower tax brings a higher return. Therefore, if you are paying a higher amount of tax on your investment, there is a high chance that you will get a lower yield and decelerate the power of compounding.

For instance, let’s imagine four friends A, B, C, and D, but they come in different tax brackets. Then, let’s see what happens with their returns.

ParticularsABCDE
Invested Amount (Rs)1,00,0001,00,0001,00,0001,00,0001,00,000
ROI (Return on Investment)10%10%10%10%10%
Term1 year1 year1 year1 year1 year
Tax Bracket0%10%15%20%25%
Interest Income before Tax (Rs)10,00010,00010,00010,00010,000
Interest Income after Tax (Rs)10,0009,0008,5008,0007,500
The Impact of Tax on the power of compounding
TABLE NO – 6

As you can observe, Mr. A has 33.33% more return than Mr. E in just one year. Then, imagine how it will affect a ten year, a 20 year, a 30 year, and a 40 year investment period. In short, just do the math and see the magic.

However, there are several tax-friendly investment options in India, like PPF (Public Provident Fund, NPS (National Pension Scheme), etc. That is to say; you should take advantage of these investment products and keep the power of compounding on your side.

The power of compounding – a closing thought

The power of compounding is nothing but a combination of time and interest income. Thus, it is a long term game that you can master to bring the power to your side. Therefore, it is not like winning a lottery; rather, it is just like watching a plant grow. Once you plant a tree and take care of it, it grows slowly and produces fruit on it over time. Most importantly, you are not eating it up and destroy the chain; instead, you plant it again to make it another big tree to have fruits on it. Therefore, it is just a mindset and nothing else. Thus, you can be a producer or a consumer of your money. But try to be a producer using the power of compounding, not a consumer of it.

I have tried to make things clear for you and hope you enjoyed the article. You can share it with your loved one with a single click. I also need your comments, suggestions, views, and opinions to improve my posts that add value in your financial life.

Thank you for being a part of the finlessons family.

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