Scientist Albert Einstein called compound interest the eighth wonder of the world. If such a great scientist can say such a big thing about compound interest, then there will be something special in it.
So in today’s article, we are going to talk about this compound interest, how it works and how we can take advantage of it in our life.
What is Compounding?
If we talk in simple language, then compounding means this – due to the interest received on our investment and also due to the interest received on that interest, the value of our investment increases.
Its main principle is that to get interest on interest also. Whenever we get some interest on our principal amount, then that interest again acts as our principal amount and then interest is also received on it.
If you have ever carefully observed the rolling balls of snow on the snowy hills, then you must have noticed that the ball continuously collects more snow with it and its size also increases. Similarly, in compound interest, interest is also available on our principal amount and the interest received on it, due to which our amount increases continuously.
Let us understand this better with an example-
Two friends X and Y invest in a fund in which they get 10% annual return, in the fund of X, they get compound interest and Y gets only simple interest, then after 10 years, their returns will be as follows –
| Description | Mr. X | Mr. Y |
|---|---|---|
| Amount Invested | 10 lakhs | 10 lakhs |
| Total amount after 1 year | 11,00,000 | 11,00,000 |
| Total amount after 2 years | 12,10,000 | 12,00,000 |
| Total amount after 10 years | 25,93,742 | 20,00,000 |
You can easily get an idea of how compound interest gives higher returns than simple interest from the above table. This is because, in compound interest, you get interest on your principal amount of 10 lakhs and after that interest of 1 lakh and after that interest of 2.1 lakhs and so on. For this reason, after 10 years, there is a significant increase in your total amount.
There are many online calculators available to calculate compound interest from where you can easily calculate your compound interest.
If you want to calculate it by yourself, then you can calculate it using this formula –
A = P (1 + [ r / n ]) ^ nt
P = Principal Amount
r = rate of interest
n = is the no. of Compounding
t = is the period the principal was invested for
3 rules to make the most of compound interest
Now we have understood very well what is compound interest and how it works, but now we will know how you can take maximum advantage of it –
You can make the most of it with the help of these three rules –
Long term advantage
If you also want to earn maximum returns by investing, then time is going to be a big contributor to it. The longer your money is invested, the higher the return you will get as you get the benefit of Exponential Growth in Compound Interest. People withdraw their amount after seeing a little profit, but they forget that the good benefit of compound interest is available only in the long term, so you should always invest for the long term.
Apart from this, to get the most out of compound interest, you should start investing as early as possible. If you start investing at the age of 20 and your friend starts at the age of 30, then you are going to get a lot of benefits from these extra 10 years in the long term.
Take a look at the rates
The most important part of compound interest is its rate i.e. at what rate you are going to get compound interest. You will get different rates on different investments. Therefore, as an investor, it becomes very important for you to analyze its rates well and only then choose the investment option.
Let’s have a look at this table once –
| Different securities | Interest rates |
|---|---|
| Bank-based savings account | 4 – 5% |
| Debt funds | 7 – 8% |
| Equity-based mutual funds | 12 – 13% |
| Shares | 15 – 16% |
The rates shown above represent the average returns from different types of investment options. Therefore, it is also possible that your portfolio may give returns much higher or lower than the rates shown above.
But the point to be noted is that you should keep on analyzing the compound interest rates you will get on your investments and make the right decision for yourself based on your financial goals and risk appetite. Even if you are borrowing money from someone, you should pay special attention to the rates so that you do not have to pay more interest due to ignorance. Apart from this, you should also be aware of the tax levied on its returns while investing.
The above three rules are very beneficial in the context of compound interest but apart from this you have to take special care about one more rule and that is discipline. Because discipline is also a big contributor to earning good returns by investing. A disciplined investor is well aware of how to make good decisions for himself without getting carried away by emotions.
Apart from this, there is another important factor – Patience. The great investor Warren Buffet has also shed a lot of light on this and has described it as a factor in getting good returns.
Conclusion
After learning any new thing, until it is not implemented in real life, we do not get the full benefit of that knowledge or skill.
Therefore, after learning about compound interest, you should try your best to apply it in your investments so that you can take advantage of its magic.
Happy Learning !!