Compounding is the eighth wonder of the world. He who understands it earns it, and he who doesn’t pays it.” - Albert Einstein
Whenever we plan to invest, it is crucial to understand the concept of interest calculation.
There are primarily two methods of calculating interest on our initial investment or principal.
First is simple interest, where interest is calculated on the principal amount.
Second is the investors' favorite, compound interest, where the interest is calculated on the principal investment and accumulated interest of past periods.
Let us learn everything about compounding so you can incorporate the power of compounding in your investments.
Suppose Mr. A invests 1000 Rs in an investment, and the interest rate is 10% p.a calculated compound. So, in this case, during the first year, Mr A will earn 100 Rs interest that will be reinvested in the principal amount. Then, in the second year, interest will be calculated at 1100 Rs (principal + accumulated interest of the past period).
Thus, it will create a chain reaction by generating interest on interest as long as the money stays invested in that particular financial instrument.
How is a calculation of simple interest different than compound interest?
For instance, there are two investors - Astha and Bharti. Both of them invest Rs 1,00,000 in separate financial instruments. Astha opts for a 10% interest rate compounded annually. Bharti opts for a 10% interest rate being calculated as simple interest.
Both of the investors keep the amount invested for ten years.
So, because of the power of compounding, interest earned by Astha in the previous period was
included in the interest computation for the next period.
The formula for calculating the compound interest:
A = P(1 + r/n)^(nt)
A = the future value of the investment, including interest
P = the principal amount (initial investment)
r = the annual interest rate
n = the number of times that interest is compounded per year
Parameters that determine the Power of Compounding
There are three parameters including: Time Duration, Tax rate and Compounding rate.
The longer the money stays uninterrupted, the more will beg rowt in the wealth.
Tax rate and timing also play an important role in the wealth accumulation . If you keep the money invested for a longer period, you might end up paying lesser taxes. Further, saving more money.
The interest rate is the returns you earn on your investments, and the higher the interest rate, the higher the power of compounding.
Hence, we can agree that compounding is immensely powerful and an effective measure of growing your wealth. You have to be patient and disciplined to benefit the most from the power of compounding. Starting investing early by keeping intact the compounding aspect can be a great headstart of your investing story.
Well Being Shiksha
Editor: Dr. Neelam Tandon
Well Being Shiksha Foundation
Founder and Managing Director