Compounding is a concept that can transform your financial future. It allows small amounts of money to grow into substantial sums over time. But how does compounding work? Let’s explore this powerful financial principle in simple, conversational terms.
What is Compounding?
Before diving deep, let’s first understand what is compounding. Compounding is when your money earns returns, and those returns also start earning. It’s like making money on your earnings.
Think of compounding as planting a tree: you start with a seed (your initial investment), which grows and bears fruit (returns). Over time, the fruits produce seeds that grow into more trees. The longer you nurture the process, the larger your forest grows.
For example, if you invest ₹1,000 at an interest rate of 10% annually, you’ll earn ₹100 in the first year. Next year, you’ll earn interest on ₹1,100 (your principal + previous year’s interest). This cycle keeps repeating, leading to exponential growth.
How Does Compound Interest Work?
Now that we know the basics let’s examine how compound interest works.
Let’s break this down with an example:
Suppose you invest ₹10,000 at an annual interest rate of 8%, compounded annually, for 5 years. By the end of 5 years, your investment will grow to ₹14,693. This includes your ₹10,000 principal and ₹4,693 in compounded interest. Let’s better understand this with step-by-step calculations.
| Year | Beginning Balance | Interest Earned (8%) | Ending Balance |
| 1 | ₹10,000 | ₹800 | ₹10,800 |
| 2 | ₹10,800 | ₹864 | ₹11,664 |
| 3 | ₹11,664 | ₹933.12 | ₹12,597.12 |
| 4 | ₹12,597.12 | ₹1,007.77 | ₹13,604.89 |
| 5 | ₹13,604.89 | ₹1,088.39 | ₹14,693.28 |
Compound Interest formula:
A = P (1 + r/n)^(nt)
Where:
- A is the future value of your investment.
- P is the initial principal amount.
- r is the annual interest rate (in decimal form).
- n is the number of times the interest is compounded per year.
- t is the time the money is invested in years.
The formula A=P(1+r/n)ntA = P(1 + r/n)^{nt}A=P(1+r/n)nt helps understand compound interest. It shows how an initial amount (P) grows over time (t) with an annual interest rate (r), compounded n times a year. It calculates the future value (A), including interest earned on the initial amount and previous interest. This compounding creates exponential growth in investments over time.
How Compounding in Stocks Works?
Compounding in stocks works by reinvesting dividends and capital gains into the investment, allowing your money to grow exponentially over time.
For example, if you invest ₹50,000 in a stock with an average annual return of 10%, compounded annually, your investment would grow to approximately ₹80,526 in 5 years. This means you would earn ₹30,526 in interest on top of your initial investment. Let’s understand the calculation step by step.
| Year | Beginning Balance | Interest Earned (10%) | Ending Balance |
| 1 | ₹50,000 | ₹5,000 | ₹55,000 |
| 2 | ₹55,000 | ₹5,500 | ₹60,500 |
| 3 | ₹60,500 | ₹6,050 | ₹66,550 |
| 4 | ₹66,550 | ₹6,655 | ₹73,205 |
| 5 | ₹73,205 | ₹7,321 | ₹80,526 |
Compound Interest vs Simple Interest
To fully appreciate the power of compounding, it’s essential to understand the difference between compound interest vs simple interest.
- Simple Interest: This is calculated only on the principal amount.
- Compound Interest: This grows exponentially as it includes accumulated interest.
For example, if you invest ₹10,000 at a 5% annual interest rate for 10 years:
- With simple interest, your total will be ₹15,000 (₹5,000 as interest).
- With compound interest, your total will be ₹16,470.
The difference grows even larger over longer periods, making compounding a powerful tool for wealth creation.
FD vs. Stocks
Let’s compare simple interest and compound interest by looking at fixed deposits. Fixed deposits use simple interest, where interest is calculated only on the initial amount, leading to steady, linear growth. In contrast, stocks grow through compound interest as dividends and gains are reinvested. This causes interest to build on both the original amount and the previous gains, creating faster, exponential growth over time.
FD (Simple Interest)
- Principal Amount: ₹20,000
- Interest Rate: 9% per annum
- Time Period: 5 years
Calculation:
- Interest Earned per Year: ₹1,800 (20,000 * 9%)
- Total Interest Earned in 5 Years: ₹9,000 (₹1,800 * 5)
- Maturity Amount: ₹29,000 (₹20,000 + ₹9,000)
Stock (Compound Interest)
- Principal Amount: ₹20,000
- Annual Return: 9%
| Year | Beginning Balance | Interest Earned (9%) | Ending Balance |
| 1 | ₹20,000 | ₹1,800 | ₹21,800 |
| 2 | ₹21,800 | ₹1,962 | ₹23,762 |
| 3 | ₹23,762 | ₹2,138.58 | ₹25,900.58 |
| 4 | ₹25,900.58 | ₹2,331.05 | ₹28,231.63 |
| 5 | ₹28,231.63 | ₹2,540.85 | ₹30,772.48 |
As you can see, with its compounding effect, the stock investment grows significantly faster than the FD, which only earns simple interest on the initial principal.
ALSO READ:
COMPOUND INTEREST VS SIMPLE INTEREST
How Does Compounding Work in Practice?
Let’s address how compounding works in real-life scenarios.
1. Savings Accounts
Banks use compounding to calculate interest on savings accounts. This means you earn interest on both your initial deposit and already earned interest. Although savings account rates are usually lower than investment returns, they provide a secure way to grow your money steadily.
2. Mutual Funds and Stock Investments
Reinvesting your returns in mutual funds or stocks amplifies compounding. A share market advisor can guide you to select stocks or funds with high growth potential, ensuring your money grows exponentially.
3. Fixed Deposits and Bonds
Fixed deposits (FDs) and bonds often offer compounded returns, depending on the financial institution. They are great for risk-averse investors looking for steady growth.
The Role of Time in Compounding
When considering how compounding works, time is your best ally. The earlier you start investing, the more time your money has to grow.
Let’s consider an example to understand how time significantly impacts the growth of an investment due to compounding.
Example:
Let’s say you invest ₹1,00,000 at an annual interest rate of 10%, compounded annually. We will calculate the value of this investment over different periods—5 years, 10 years, and 20 years—to observe the role of time.
A=P×(1+r)n
Where:
- A = Future Value
- P = Principal Amount (₹1,00,000)
- r= Annual Interest Rate (10% or 0.10)
- n = Time (in years)
| Case 1: After 5 Years | Case 2: After 10 Years | Case 3: After 20 Years |
| A = ₹1,61,051 | A = ₹2,59,374Value after 10 years: ₹2,59,374 Interest Earned: ₹1,59,374 | A = ₹6,72,750Value after 20 years: ₹6,72,750 Interest Earned: ₹5,72,750 |
Observations:
- Shorter Time Period (5 years): The investment grew by only ₹61,051.
- Moderate Time Period (10 years): The growth was more significant, ₹1,59,374.
- Longer Time Period (20 years): The compounding effect became exponential, adding ₹5,72,750 in interest.
How Does Compounding Work with SIPs?
Systematic Investment Plans (SIPs) are one of the easiest ways to leverage compounding. You can build wealth over time by investing small, fixed amounts regularly.
Let’s illustrate how a monthly SIP of ₹10,000 at a 12% annual return grows over 20 years.
| Year | Total Invested (₹) | Growth from Compounding (₹) | Total Value |
| 1 | 1,20,000 | 7,286 | 1,27,286 |
| 2 | 2,40,000 | 32,977 | 2,72,977 |
| 3 | 3,60,000 | 75,570 | 4,35,570 |
| 4 | 4,80,000 | 1,36,763 | 6,16,763 |
| 5 | 6,00,000 | 2,18,418 | 8,18,418 |
| 10 | 12,00,000 | 10,92,939 | 22,92,939 |
| 15 | 18,00,000 | 28,42,456 | 46,42,456 |
| 20 | 24,00,000 | 76,36,400 | 1,00, 36,400 |
Observation:
Total Invested (₹): This is the cumulative amount you have invested through monthly SIPs. For example, after 5 years, the total investment is ₹6,00,000 (₹10,000 × 60 months).
Growth from Compounding (₹): The wealth generated through compounding over the years. For instance, by the 10th year, compounding adds ₹10,92,939 to your total.
Total Value (₹): The sum of the total invested amount and the growth from compounding. By the end of 20 years, your investment will grow to ₹1,00,36,400.
Why is compounding necessary with the rising inflation?
Inflation reduces the purchasing power of your money over time. Therefore, your investments need to grow faster than inflation. Compounding can help you achieve this, especially when investing in equity or mutual funds that typically offer higher returns.
Final Thoughts
So, how does compounding work? It’s about letting your money grow by reinvesting returns and staying committed for the long term. By starting early, being consistent, and choosing growth-oriented investments, you can leverage the power of compounding to achieve your financial goals.
Consult a share market advisor and use tools like a CAGR calculator to maximize compounding’s potential. Understanding compounding and applying its principles can transform your financial future.
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FAQ
What is Compounding?
Compounding is the process of earning interest on your initial investment and the interest it generates over time. It’s like a snowball rolling downhill, growing larger as it accumulates more snow.
Why is Compounding Important?
Compounding is a powerful tool for wealth accumulation. It allows your money to work harder for you over the long term. The earlier you start investing, the more time your money has to grow exponentially.
How Does Compounding Work?
Let’s say you invest $1000 at a 10% annual return. In the first year, you’ll earn $100. In the second year, you’ll earn 10% on your initial $1000 and the $100 interest, resulting in $110. This cycle continues, accelerating your returns over time.
How Can I Start Compounding My Wealth?
Start by setting aside a portion of your income regularly. Invest in low-cost index funds or other suitable investment vehicles. Be patient and let the power of compounding work its magic. Remember, consistency is key.
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.
