What is Compounding: The Key To Financial Freedom

Have you ever wondered how some people manage to amass vast fortunes while others struggle to make ends meet? The answer is straightforward: the Power of Compounding. Many investors claim to understand compounding, nicknamed the “eighth wonder of the world,” but only a few know how to use it to build long-term wealth.

In this article, we will look at the power of What is compounding and explain how it works, why it is essential for long-term investing, and how you can use it to achieve your financial goals.

What is Compound Interest?

Imagine you have a magic piggy bank that can make your money grow. Every year, it adds a certain percentage of your money to your piggy bank as a reward for saving. This percentage is called the interest rate. For example, if you have Rs. 100 in your piggy bank, and the interest rate is 10%, then after one year, you will have Rs. 110 in your piggy bank. That’s Rs. 100 of your original money plus Rs. 10 of interest.

But the magic doesn’t stop there. Next year, your piggy bank will add another 10% of your new balance to your piggy bank. That means you will have Rs. 121 in your piggy bank after two years. That’s Rs. 110 of your previous balance plus Rs. 11 of interest. Notice that the interest amount increased from Rs. 10 to Rs. 11. That’s because you earned interest on your interest. This is the “Power of Compounding,” which means: earning interest on your interest.

The longer you keep your money in the magic piggy bank, the faster it will grow. After 10 years, you will have Rs. 259 in your piggy bank. After 20 years, you will have Rs. 673. After 30 years, you will have Rs. 1,745. And after 40 years, you will have Rs. 4,526! All from an initial investment of Rs. 100 and a constant interest rate of 10%. Such magnificent is the power of compound interest in long-term investing!

Of course, in real life, there is no such thing as a magic piggy bank. But some financial products work similarly, such as Mutual Funds, fixed deposits, bonds, and stocks. These investment vehicles can facilitate your wealth growth over time. However, they also come with different risks and returns, so you must research and choose wisely.

How Does Compounding Work?

If you want to supercharge your savings and investments, you need to understand the power of compound interest in long term investing. Compounding is when you earn interest on your interest or returns on your returns. It means that your money grows faster and faster as time goes by because you make money not only on your original investment but also on the accumulated earnings from previous periods.

Let’s look at some simple formulas and examples to feel the magical power of compound interest in long-term investing. Let’s say three friends, Harry, Ron, and Hermione, start their investment journey and start with an investment of Rs. 1000 in a savings account that pays 5% interest per year, compounded monthly. We will consider two cases-

Case 1: Power of Compounding with One-time Investment

1. One-time Investment: One-time investment of Rs. 1000/- made. Formula used-

FV = PV x (1 + i/n)^(nt) 
where:FV = future value, PV = present value, i = annual interest rate, 
n = annual count of compounding periods,  t = number of years

	Harry	Ron	Hermione
Entry Age	25 years	30 years	20 years
Investment made	Rs. 1000/-	Rs. 1000/-	Rs. 1000/-
Compounding Rate	5%	5%	5%
Value of investment at the age of 45	Rs. 2653.30	Rs. 2078.90	Rs. 3386.40
Total interest earned	Rs. 1653/-	Rs. 1078.90	Rs. 2386.40

Case 2: Power of Compounding with Dolar Cost Averaging (DCA)

Regular Investing or Dolar Cost Investing (DCA): Regular investment of Rs. 1000/- monthly. The formula for the future value Annuity (FVA) of an investment with compounding is:

FVA = PMT x ((1 + i/n)^(nt) - 1)/(i/n)

where: PMT = payment amount each month, i = annual interest rate, 
n = annual count of compounding periods, t = number of years

	Harry	Ron	Hermione
Entry Age	25 years	30 years	20 years
Investment (each month)	Rs. 1000/-	Rs. 1000/-	Rs. 1000/-
Compounding Rate	5%	5%	5%
Value of investment at the age of 45	Rs. 396,852.80	Rs. 258,348.70	Rs. 572,762.60
Period of Investment	20 years	15 years	25 years
Total Contribution made	Rs. 2,40,000/-	Rs. 1,80,000/-	Rs. 3,00,000/-
Total interest earned	Rs. 1,56,852.80	Rs. 78,348.70	Rs. 2,72,762.60

Patience is required for significant gains.  Market timing does not produce long-term returns. To become wealthy by perfectly timing the market, you must have exceptional skills and experience.  The safest way to invest is to be patient and consistent and let the power of compounding work its magic. 

How Can You Improve Your Savings With Compounding Benefits?

Saving money is a smart and responsible habit that can help you achieve your financial goals and dreams. Whether you are saving for a home, a car, a vacation, or retirement, you want your money to grow as much as possible over time. But how can you make your savings work harder for you? The answer is the Power of compounding.

Of course, in real life, many factors can affect your savings growth, such as inflation, taxes, fees, and market fluctuations. But the principle of compounding remains true: the more time you give your money to grow, and the higher the interest rate you earn, the more money you will have.

How to Improve Your Savings With The Benefits of The Power of Compounding?

Here are some tips:

• Start saving early: The earlier you start saving, the more time you have for compounding to work its magic. Even if you start with a small amount, it can grow significantly over time if you keep saving and investing regularly.

• Save more: The more money you save and invest, the more you will earn from compounding. Try to increase your savings rate as much as possible by cutting unnecessary expenses and increasing your income sources.

• Choose high-interest products: The higher the interest rate you earn on your savings and investments, the faster they will grow with the power of compounding. Look for products that offer competitive and consistent returns over time, such as equity and Debt funds, bonds, and stocks.

• Reinvest your earnings: To maximize the benefits of compounding, make sure you reinvest your earnings instead of spending them or withdrawing them from your account. This way, with the Power of Compounding, you can earn interest on your interest and increase your savings balance exponentially.
• Avoid fees and penalties: Fees and penalties can reduce your savings growth and negate the benefits of compounding. Try to avoid products that charge high fees or impose penalties for early withdrawals or late payments.

• Review and adjust: “Power of Compounding” is not a set-it-and-forget-it strategy. You must review and adjust your savings plan periodically to ensure it aligns with your goals and needs. Depending on your situation and preferences, you may need to change your products, rates, amounts, or frequencies.

The power of Compounding is one of the most important concepts in finance and investing. It can help you improve your savings and achieve your financial goals and dreams faster and easier than you think.

Power of Compounding: Is Monthly or Daily Compounding Better?

The frequency of compounding is directly proportional to your gains over the long term. Let us change the compounding frequency in the cases discussed above to daily instead of monthly to see how the power of compounding works then-

Compounding Frequency	Harry	Ron	Hermione
Monthly	Rs. 396,852.80	Rs. 258,348.70	Rs. 572,762.60
Daily	Rs. 397,392.70	Rs. 258,715.90	Rs. 573,775.60
Difference	Rs. 539.90 (in 20 years)	Rs. 367.90 (in 15 years)	Rs. 1013 (in 25 years)

The table highlights how a small change can have a big impact. When the power of compounding is viewed over time, this difference becomes even more pronounced.

Key Takeaways

Compounding can help you boost your savings and wealth over time by earning money on your money. Following the tips in this article, you can take advantage of compounding and achieve your financial goals. Remember, the Power of compounding is the secret sauce to saving and investing success. Don’t let this opportunity pass you by!

Start saving and investing today, and let compounding work wonders for you!

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Read more:  How Long-term investing helps create life-changing wealth – TOI.