| First Principle: There is no such thing as simple
interest
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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.
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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'.
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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!!
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| Second Principle: The smallest rate differential has a
BIG impact over time
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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.
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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.
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| The Impact of Power of Compounding
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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 |
5% |
10% |
15% |
20% |
| 1 |
Rs 105 |
Rs 110 |
Rs 115 |
Rs 120 |
| 5 |
Rs 128 |
Rs 161 |
Rs 201
|
Rs 249 |
| 10 |
Rs 163 |
Rs 259 |
Rs 405 |
Rs 619 |
| 15 |
Rs 208 |
Rs 418 |
Rs 814 |
Rs 1541 |
| 25 |
Rs 339 |
Rs 1,083 |
Rs 3,292 |
Rs 9,540 |
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 Top |
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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.
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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!
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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!!!
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We continue our discussion of the impact of the power of
compounding on account of inflation and taxes and hence on your financial
wealth in our article Running To Stand Still.
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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.
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