Introduction:
If you invest Rs.10,000 in a plan with 10% simple interest for 5 years, you’ll get Rs.15,000 at maturity. But with 10% annual compound interest, the same Rs.10,000 grows to Rs.16,105. This example clarifies that compounding gives a higher return than simple interest.
But how? What is compounding? How does it work? Let’s understand with examples of compounding.
What Is Compound Interest?
Compound interest is when interest is calculated on the initial amount you invested and the already added interest. You’re earning interest on your interest. This method makes your money grow faster than if simple interest were applied, which only considers the principal amount.
In compounding, the principal amount increases every time the accumulated interest is added at a calculation point. This is why compounding is also seen as the plan that gives ‘interest on interest.’
Let’s understand this better with compounding examples.
Say you invested Rs.1,50,000 for 10 years in a fund with 12% interest compounded annually. After every year, the carried forward amount will gather 12% interest and will result in an output that looks like this in a CAGR calculator–
| Year | Principal for the year (Rs.) | Interest (at 12%) | Amount carried forward (Rs.) |
| 1 | 1,50,000 | 18,000 | 1,68,000 |
| 2 | 1,68,000 | 20,160 | 1,88,160 |
| 3 | 1,88,160 | 22,579.20 | 2,10,739.20 |
| 4 | 2,10,739.20 | 25,288.70 | 2,36,027.90 |
| 5 | 2,36,027.90 | 28,323.35 | 2,64,351.25 |
| 6 | 2,64,351.25 | 31,722.15 | 2,96,073.40 |
| 7 | 2,96,073.40 | 35,528.81 | 3,31,602.21 |
| 8 | 3,31,602.21 | 39,792.26 | 3,71,394.47 |
| 9 | 3,71,394.47 | 44,567.34 | 4,15,961.81 |
| 10 | 4,15,961.81 | 49,915.42 | 4,65,877.23 |
| Total Interest | 3,15,877 |
In this compounding example, the interest of the first year, Rs.18,000, is added to the principal amount for the second year, and the interest is computed again on the entire sum of Rs.1,68,000. The process is carried out for the whole tenure of the plan or fund. This is compound interest.
Instead of the table, a more direct way of calculating compound interest is by using the compound interest formula-
Compound Interest = Total Amount – Principal
where,
Amount = P (1 + r/n) ^ nt
In this, ‘r’ stands for the rate of interest divided by 100, ‘n’ represents the tenure in years, ‘t’ stands for the frequency of compounding, and ‘P’ is the principal.
According to the formula, if we substitute the value of the same example, that is
- P = 1,50,000
- r = 12/100 = 0.12
- n = 10
- t = 1 (annual compounding)
Amount = 150000 [(1 + 0.12/10) ^ 10*1] = Rs.4,65,877.23
Compound Interest Vs. Simple Interest:
Simple interest and compound interest differ mainly in how the interest is calculated. With simple interest, the interest is calculated only on the initial invested amount (principal). This means that each time interest is added, it’s based on the original principal amount and doesn’t change over time.
On the other hand, compound interest is calculated not just on the principal but also on the interest that accumulates. It means that each time interest is added, it’s added to the principal, increasing the amount on which future interest is calculated. As a result, compound interest grows your investment faster.
Let’s take a compounding example and a simple interest example to compare.
Say you invest Rs.20,000 each in funds offering simple interest and compound interest of 15% p.a. for 10 years. This is how differently the corpus will grow in both scenarios-
| Year | Compound Interest (Rs.) | Simple Interest (Rs.) |
| 1 | 23,000 | 23000 |
| 2 | 26,450 | 26000 |
| 3 | 30,417.50 | 29000 |
| 4 | 34,980.13 | 32000 |
| 5 | 40,227.15 | 35000 |
| 6 | 46,261.22 | 38000 |
| 7 | 53,200.40 | 41000 |
| 8 | 61,180.46 | 44000 |
| 9 | 70,357.53 | 47000 |
| 10 | 80,911.16 | 50000 |
Because of the difference in how each model works, compound interest generally leads to higher returns than simple interest. Simple interest offers a more predictable and stable return, while compound interest can significantly increase your returns over time, especially when invested for longer periods.
How To Best Use The Power Of Compounding?
Start Early
Starting as early as possible is the best way to use compounding. The sooner you begin investing, the better your wealth will grow over time when you stay invested.
Discipline
Set clear financial goals and stick to consistent investments to build a healthy portfolio. Even if your earnings are small, being disciplined now will pay off later and help you develop the habit of saving for investing.
Be Patient
We all want quick returns, but long-term investments genuinely benefit from compounding. Let your investment grow without interrupting it. Over time, this will build a strong lump sum for you.
Invest in Options that Compound More Frequently
Investments with more frequent compounding help your wealth grow faster. For example, a Rs.1000 investment with quarterly compounding will grow to Rs.1,750 in 20 years, while annual compounding would grow to Rs.1,500. Minor differences add up over time.
Step Up Your Investments
As your income grows, increase your investment. More money means more interest, and that interest will compound. Even small increases can lead to huge growth over time.
ALSO READ:
COMPOUND INTEREST VS SIMPLE INTEREST
How Does Compounding Work in Practice?
Take Expert Help
If you’re unsure where, when, and how to invest, an expert like a registered share market advisory can help. Based on your financial goals and situation, they’ll help create a personalized plan to maximize the power of compounding.
Bottomline:
Compound interest has a robust long-term effect on savings and investments. It is a great way to take advantage of money’s time value and helps offset inflation’s impact on your cost of living. Just remember to choose the right investment avenues based on factors like compounding frequency, rate of interest, and tenure and ensure they align with your financial goals.
Disclaimer Note: The securities quoted, if any, are for illustration only and are not recommendatory. This article is for education purposes only and shall not be considered as a recommendation or investment advice by Equentis – Research & Ranking. We will not be liable for any losses that may occur. Investments in the securities market are subject to market risks. Read all the related documents carefully before investing. Registration granted by SEBI, membership of BASL & the certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.
FAQ
What is the ‘rule of 72’?
The Rule of 72 helps estimate how long it will take for your money to double when compounded annually. Simply divide 72 by the interest rate (r). For example, if your investment earns r%, it will take 72/r years to double.
The rule is also useful for understanding how inflation impacts your money. It shows how many years it’ll take for the value of your asset to halve if it depreciates annually.Who gets the benefits of compound interest?
Compound interest benefits everyone, from investors to banks. Banks lend money and reinvest the interest they earn into more loans, growing their profits. Depositors also benefit by earning interest on their savings, bonds, or other investments.
Which investment options offer compound interest?
Several investment options offer compounding interest. You can pick one based on your investment goals and how much risk you’re comfortable with. Some possibilities include Mutual Funds, Certificates of Deposit, Stocks, Bonds, FDs, RDs, and more.
I’m Archana R. Chettiar, an experienced content creator with
an affinity for writing on personal finance and other financial content. I
love to write on equity investing, retirement, managing money, and more.
