First Principle: There is no such thing as simple interest
Simply put, compounding refers to the re-investment of income at the same rate of return to constantly grow the principal amount, year after year. Cumulative fixed deposits are a prime example of compounding at work, wherein the total interest that you get paid for the period is in excess of the rate of interest multiplied by the period of the deposit.
You often see advertisements taken by borrowers of money (e.g., banks, finance companies, manufacturing companies, etc) who promise you rates of return that seem to be far in excess of prevailing interest rates. These advertisements are very often misleading because what the borrower is referring to is the simple interest that you will earn during the period of your investment. And not the `rate of interest' that is being compounded each year. Which brings us to the first principle of compounding. `There is no such thing as simple interest'.
And it would help your financial cause a great deal if you applied this principle when you invest or lend money. Because anyone who lends you money is sure to apply it!!
Second Principle: The smallest rate differential has a BIG impact over time
Would you care too much whether your rate of return is 12% or 14%? The fact is that if you did, it would make a big difference to your wealth as time progresses. The benefit from compounding arises primarily from the fact that income keeps growing the principal to generate higher absolute returns each year. Higher rates of return or longer investment time periods increase the principal amount in geometric proportions.
The table below shows you how a single investment of Rs100 will grow at various rates of return. 5% is what you might get by leaving your money in a savings bank account, 10% is typically the rate of return you could expect from a one-year bank fixed deposit, 15% is what you could expect by investing in relatively riskier company fixed deposits and 20% or more is what you might get if you prudently invest in equity shares.
The Impact of Power of Compounding
Use the table below, to see the impact of the power of compounding with different rates of return and different time periods.
|At end of Year
By now, you've probably figured out the obvious conclusion from the above table. You can also use our Magic of Compounding calculator to understand the same.
It is literally 'a waste of time and money' to let your wealth lie in low-income investments for prolonged periods of time. You�ve obviously also realised that TIME is the magic wand for compounding!! For shorter periods of time, although different rates of return do result in different wealth levels, the impact is not earth shattering. However, the longer the period for which the investment is made (say over 10 years in our above example) the difference just cannot be ignored!
And yes, the next time you plan to borrow money, remember that compounding is busy working against you. Make sure you are conscious about the cost of your borrowing. Every time your credit card payment is running overdue, you are not paying just 2% per month in interest cost, you are actually paying 26.8% per annum!!!
In Benefits of Starting To Invest Early we discuss how, because of the Power of Compounding, it makes a lot of sense for you to start investing right now.