Power of Compounding
The concept of compound interest that you studied back in high school can turn a few rupees into a sizeable amount over time.
This simple but powerful concept of investing acts as a multiplier in your investment portfolio. The great thing about compounding is that you will eventually reach a point where the amount of money reinvested will become greater than the original principal amount. All you need to do is start investing early and over time, compounding will grow your money for you.
What is Compounding?
Compound interest or compounding means you not only receive the interest on the basic principal amount that you have invested, but also on the interest that keeps getting added to it. It essentially means reinvesting the earnings you get from your initial invested amount instead of spending it elsewhere. For example, if you invest ₹100 with 8% interest every year, then your principal amount is ₹100 and the earnings, at the end of the year, are ₹8 (8% of ₹100). However, instead of spending it, if you choose to reinvest it, then your principal amount for the next year becomes ₹108 (₹100 + ₹8) and the earnings you get are ₹8.64 (8% of ₹108), which are ₹0.64 more compared to the first year.
Even though this looks like a small amount, it can make a huge difference to your investments, if you let the magic of compounding work over a long term.
How Compound Interest works in Investments
Consider an example to understand how the power of compounding works:
Ravi invested ₹1,00,000 as a lump sum this year. He is going to earn an interest of 12% on this investment every year. Now let’s see how much interest Ravi earns over 10 years, if he takes his interest out each year, as compared to letting the principle of compounding work for him.
You can see that by merely reinvesting the interest earned on his principal amount, Ravi manages to earn almost double the interest on his one-time investment as compared to him taking his interest out each year. This shows the power of compounding.
The way compounding works, the more you invest at a young age, the more your money works for you over time and the sooner you’ll achieve financial freedom. Hence, to invest wisely, it is important that you leverage the power of compounding and start saving & investing early.
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