Even if you were a backbencher in school, no one in a Math class can stay unaffected by the magic of compounding! What we learnt then is now going to come in handy. Compounding is the process of earning interest on a simple income instrument - the interest itself can earn interest! Simply put, interest previously calculated is included in the calculation of future interest.

Let's look at this example: Let us suppose that Raj invests Rs 1,00,000 at the rate of 1% interest per month, compounding each month.

  • The interest paid to him in the first month is Rs 1000 (1% of Rs 1,00,000).
  • In the second month, he will earn Rs 1,010 (1% of Rs 1,01,000, and so on and so forth).

In this case, the frequency of interest compounded will give him higher returns.

Consider the example of Reshma and Gloria, who are both starting their careers.

From age 25, Gloria saves Rs 5,000 a month in an SIP. It generates a return of 12% per year on average. Gloria continues to invest this amount until the age of 55, or for 30 years, her total contribution amounting to Rs 18,00,000.

Reshma, on the other hand, is 40 when she decides she needs to make sure she has money saved for retirement. She invests Rs 10,000 a month in an SIP and also gets an average return of 12%. She is starting later than planned, but she's certain she will catch up to Gloria– she has 15 years until she retires.

By age 55, Reshma has invested the same amount as Gloria — Rs 18,00,000. She has caught up!

However, because of the benefit of time – a head start of 15 years – Gloria's investment gives her a valuation of Rs 1.76 Crore, compared to Reshma's valuation of Rs 50.45 lakhs! Those 15 years make a remarkable difference and illustrate the benefit of saving – and putting compound interest to work – as early as possible.

  Gloria Reshma
Starting age of SIP 25 40
SIP continued till (age) 55 55
Total years of investment 30 15
SIP Installment amount (Rs.) 5,000 10,000
Total Investment (Rs.) 18,00,000 18,00,000
Valuation (Rs.) 1,76,49,569 50,45,760

If you are in your 20s and 30s, you have time to build up a retirement nest egg – and you have a powerful friend called compound interest, which is a smart name for earning interest on interest.
Even if you are already in your 30s or 40s, it is never too late to start saving for your retirement, but the younger you are when you start, the more you stand to benefit and the less money you need to put away each month compared with somebody starting to save in later years. It's all about allowing time for your money to grow.

It is no wonder then that Albert Einstein is said to have called the power of compound interest the most powerful force in the universe!  

Anyone can make compounding work for themselves:

  • Begin the saving habit as early as possible and
  • Save regularly.

If you invest 1 lakh and allow it to compound at 12%, you will have Rs. 3.1 lacs after 10 years, Rs. 9.6 lacs after 20 years and Rs. 30 lacs after 30 years. In the 1st 10 years you earn Rs. 2.1 lacs, the 2nd 10 years period Rs. 5.5 lacs and in the 3rd next 10 years Rs. 20.4 lacs! And, the earnings will go on increasing exponentially! So, have patience, allow compounding to work.

If the power of compound interest is understood at a young age, one would have a great incentive to begin saving early. Those who grasp the implications, enjoy huge financial benefits.

Systematic Investment Plans help you develop the habit of regular saving without having to devote too much time in following up and making manual payments. Set up an SIP today, after all, in case of compound interest, time is money!

 

Disclaimer: Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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