Imagine, you keep your favorite Chocolate in a magical box and spell few words and the Chocolate just double itself. Won’t you be happy? What if i give you a magical mantra which can just double your bank balance. And why just double and not triple? Five times or Hundred times? So here you go..Abraka Dabra the magical spell is “Compounding”.
What is Compounding?
Compounding takes place when the interest generated on the principal in the first period is added back to the principal in order to calculate the interest for the following periods. Thus, generating returns on the returns becomes a chain reaction as long as your money remains invested in the financial instrument.
The more frequently your money earns interest, the faster and bigger your balance will grow. As interest is added to your account, you earn interest on the original balance, plus the previously earned interest.
Care for an Example?
Let us understand the magic of compounding with the help of an example. Suppose there are two investors Harry and Jerry who are looking for opportunities to create wealth. They spot an opportunity where interest can be earned at the rate of 10%. Both of them decide to stay invested for a period of 5 years. Harry opts for interest being calculated as compound interest while Jerry opts for interest being calculated as simple interest.
At the end of 5 years, Lets see where Harry and Jerry Stands:
| Particulars | Investor A | Investor B |
| Principal invested | 100000 | 100000 |
| Rate of Interest | 10% | 10% |
| Duration of Investment (in years) | 5 | 5 |
| Amount at maturity (in Rs) | 161,051 | 150,000 |
| Difference in final value (in Rs) | 11,051 |
Because of compound interest, in case of Harry, the interest that Harry earned in the previous period was included in interest computation for the next period. In case of Jerry, for every period, interest was calculated on the initial principal only. Because of the power of compounding, Harry the wiser became richer than Jerry the ignorant.
How do I make the magic of compounding work for me?
Time – Invest as early as possible. Do not think that you are too young to invest or think about the future. Just like the early bird catches the worm, the earlier you invest the more rewards you reap.
Stay Invested – Do not withdraw money unless it is an emergency and there are no other means for funding. You should not use the invested money for paying off personal loans, credit card dues or buying luxury items. It is important to keep away from such frivolous expenses.
Grow your investment – No matter how tiny the amount is, incremental investments do wonder to the wealth building process. Set aside some amount from your income for investment purposes.
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