Power Of Compounding

What is Compounding?

Compounding is the ability of the amount invested to earn interest and generate interest on both the amount invested previously and the interest earned previously. over time both principal and interest accumulate accelerating the income for a while for which it is aimed or until the desired financial objective/goal is achieved.

Compounding Vs Simple Interest :

In Compounding both the Principal and the Interest earned on the principal further attracts interest on both principal and previously earned interest, thereby increasing the value of money faster as compared to Simple Interest where after a predecided time the interest amount is the same as generated the previous time on the principal, in Simple Interest you get the same interest on the principal every time it is calculated.

Compounding Vs Inflation :

Inflation is a disease that sweeps away your savings , if not properly and timely handled. In today's time one is affected by inflation due to high prices of various products and services. It is therefore important that one should use his savings to invest carefully in instruments that generate higher returns than the rate of inflation for example if the rate of retail inflation is 7% then the returns one should earns from his savings invested should be 10-12% p.a, then it can be said that inflation is taken care and wealth creation is happening as against the scenario where inflation is 7% and the rate at which savings are growing 6.5% p.a in such a scenario, it is said that one is paying more than earning.

Common Compounding Instruments :

Fixed Deposits, Recurring Deposits, Bonds, Mutual Funds, Systematic Investment Plans( SIP).

How Compounding Works: 

For example, a Person in his 20s wants to buy a house by the age of 50 years of Rs 1 Crore. Assuming he starts an Equity Mutual Fund SIP at 20 years with a monthly investment of Rs 5000/month for the next 30 years, assuming his investment compounds @12% P.A for the next 30 years. Then the total principal amount invested by him till 30 years is Rs 18,00,000/-( 5000/month*30yrs)and the current market value of that invested is 18,00,000 @12%P. A at 50 yrs would be Rs. 1,76,49,569. Only the profit made by him is Rs. 1,58,49,569( 1,79,49,569-18,00,000). This is the Power of Compounding which would be impossible in 30 years had the same be based on Simple Interest calculation.

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