The Power of Compounding

You must have often heard or read about the ‘power of compounding’ and if you are not conversant with matters of finance, you may not know what it actually means. Actually, it is quite simple: It just means that you get paid interest on the principal amount as well as on the accrued interest at regular intervals. The exponential effect of this power of compounding is astounding. No wonder, the great physicist and Nobel laureate Albert Einstein called compound interest the “Eighth wonder of the world” and added “He who understands it, earns it; he who doesn’t, pays it!” Einstein very well understood the power of compounding and probably earned his interest as well!

Let us understand the power of compounding with an example. If you had invested Rs 10,000 for 10 years at a simple interest rate of 7% and another Rs 10,000 for 10 years at a compound interest rate of 7% (compounded annually), the results would be astounding. At the simple rate of interest, the total amount of interest you would be earning would be Rs 7,000 in 10 years (Rs 700 per year x 10 years). However, at the compounded rate of 7%, the total amount of interest you would be earning would be more than Rs 9,671. The difference between simple and compound interest is Rs 2,671 (Rs 9,671 minus Rs 7,000). So, the return earned by way of compound interest is higher by 38.15% as compared to the return earned through simple interest. Now, imagine how much of difference will it make if the investment period is for a longer duration of, say, 20 years or 30 years. The difference, needless to say, would be huge.

Hence, to get the full advantage of the power of compounding, you need to begin early in life and invest over the long term.