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How Compounding Can Make You Rich?

IndianMoney.com Research Team | Posted On Monday, April 22,2019, 03:00 PM

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How Compounding Can Make You Rich?

 

 

What Is Compound Interest?

In simple words, compound interest is the interest earned on interest. It is the outcome of reinvesting the interest, instead of paying it out. The interest earned is added to the principal and interest is again calculated on the whole amount.

With compound interest, your investment grows much faster. Compound Interest allows an investor to earn more on the investment. Compound Interest is compounded on a daily, monthly or a quarterly basis, as per the agreement. Higher the number of compounding higher would be returns. So, longer the investment tenure, higher would be returns.

In compound interest, the interest earned is not paid out; it is instead reinvested to enhance the principal which in turn generates higher returns in the next compounding period. The formula to calculate compound interest is:

A= P (1+(r/n))nt

Where;

A – Corpus at the end of compounding period

P – Principal invested

r – Rate of interest

n - Number of compounding per year

t – Tenure of investment in years

CI = A – P;

CI – Compound Interest

Types of Investment

There are many investment options that offer compound interest on your principal. The popular compound interest investment options are:

  • Banks and Credit Unions: Some banks and credit agencies offer compound interest on savings and checking accounts.
  • Zero-Coupon Bonds: Zero-Coupon bonds generally pay compound interest. Zero-Coupon bonds are those bonds that are bought at a discounted face value; they accumulate interest over the tenure of the bond and pay out a face value when the bond is redeemed. The accumulated interest usually accrues compound interest, which is paid out to the bond holder when the bond matures.
  • Five Percent Account: Investing Rs. 10,000 in a scheme offering an annual interest at 5% would earn Rs. 500 after a year at simple interest. If the account offers compound interest semi-annually, then the investment would earn Rs. 506.25 and daily compounding would yield Rs 512.67.

As the amount of money you invest goes up, the compound interest makes a bigger difference to your earnings. Hence, it is a good idea to understand how compounding works on your investments and bank accounts.

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How Compounding can Make you Rich? Explain with Example

Let’s say you invest Rs 5,000 in a scheme offering compound interest and the scheme offers an annual interest rate at 5%. If the interest is compounded on a monthly basis, then the value of the investment at the end of 10 years is calculated as follows:

P = 5000.
r = 5/100 = 0.05
n = 12.
t = 10.

By substituting these values in the formula:

A= P(1+(r/n))nt

A = 5000 (1 + 0.05 / 12) (12 * 10) = Rs. 8,235.05.

Therefore, the investment at the end of 10 years would be Rs. 8,235.05.

SEE ALSO: ELSS - Utilizing the Power of Compounding

The Rule of 72

The Rule of 72 is the simplest way of estimating how long an investment would take to double, when given a fixed annual rate of interest. The rule of 72 is accurate specifically when the interest rates are low. The rule of 72 divides the number 72 by the annual rate of interest. With this, investors get a rough idea on how long an investment takes to double.

If the interest rate offered is 8% on an investment of Rs 4,00,000, then as per the rule of 72, the investment would double in:

Time (T) = 72 / x; Where x = interest rate

T = 72/8 = 9 years;

Hence, an FD offering returns at 8% will double your investment in 9 years. Compound interest requires longer time to earn maximum benefits and therefore, fixed deposits are of longer duration.

Advantages of Compound Interest:

  • Offers better returns than simple interest.
  • The interest is compounded over time.
  • Good way of managing your wealth.
  • Rapid return on investments.

Facts About Compound Interest That you Must Know

  • To enjoy benefits of compound interest, you must sacrifice today to reap the benefits of tomorrow. Compound interest requires longer investment tenure to enjoy the best results. It’s better to start planning for the future by investing in schemes that offer returns based on compound interest.
  • You need not be rich to enjoy returns of compound interest. You get corresponding returns on your investment, be it Rs. 100 or Rs. 10 Lakhs.
  • Compound interest is a double-edged sword. Compound interest can work against you, if you have borrowed money and have to pay compound interest.
  • Compounding of the interest can be done as often as possible. More the number of compounding more would be the returns earned. It’s good to compound on a quarterly basis over annual basis. Opposite is true when you have borrowed.
  • Compound interest works much faster than you think. Consider investing Rs.5 each month in a compound interest scheme offering returns at 5% compounded each month. Investing Rs. 5 continuously for 10 years, you would have Rs. 600 in your account, but the account would be worth Rs. 776 because of compound interest. Even if you don’t add a single rupee to the account, it would still be worth Rs. 1,500 by the end of the next 15 years.
  • Time is not on your side. Credit cards and loans levy heavy compound interest. This is the reason why paying just the minimum payments increases debt.

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