The art of Compounding
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” - Albert Einstein
All of us are well aware of the Eighth Wonder of the World as said by Albert Einstein: Compounding. Compounding can do magic not only to your money but also to your relationships, network & many other things. A person can either use compounding in their favour or against them. One can make money while they are sleeping with the power of compounding, and also mount debt in the same sleep. Curious right? Let us explain to you the enriching concept of compounding and how you can use this double-edged sword in the long run!
When a person re-invests their asset earnings at the same rate of returns, the principal amount & interest earned increases with each day is called compounding. This results in an overall increase in investment over-time. This concept is also known as the Time Value of Money. Compounding not only works on assets but on liabilities too. With the increase in the value of the assets over time, it also accumulates the liabilities such as the amount of money owed on a loan, as the interest accumulates on the unsettled principal.
Compounding can be best comprehended with the help of an example. Let us explain to you with the help of it.
There were two college friends Katie & Rohan who started investing at different ages.
Katie invested Rs. 8000 every month from the age of 20 till age 40 & Rohan started investing every month Rs. 15000 at the age of 35 till age 50. Let’s assume both of them invested in the same instrument with a 12% rate of return. Can you make a guess who will have the highest returns?
At the age of 50, Katie will have Rs. 2.48 crore & Rohan will have Rs. 75.69 Lakhs.
Surprising right! Even when Rohan invested a higher amount than Katie, his returns are still low. Katie invested only for 20 years and stopped investing after the age of 40 and Rohan invested a higher amount till the age of 50, then to this resulted in Katie bagging more returns.
The above example gives us a clear message that you should start investing early to see the magic of compounding. Investing early is a habit that needs to be inculcated in the minds of youngsters. Getting quick-rich schemes doesn’t work for a long time, instead, the focus should remain on wealth creation. One main challenge which almost everyone faces is being invested in the long run. Wealth is always formed in the long-run and not in a short period. Separating savings & expenses should be a priority and not procrastination. A person should always save first before spending their money. This will help in sowing the seeds for saving habits which will reap as a compounding effect in the future.
We have seen when compounding works for us and how we can start saving and investing early to give it a kick-start. Now, let us also take a look when compounding works against us and how a person can land into trouble. The classic example of debt mounting is credit cards.
For instance, if you have a credit card & you don’t pay your complete amount by the initial due date, you are trapping yourself in compound interest.
In the above chart, you can observe how the interest is added back to the principal amount, and the next interest charged is added to the outstanding principal. This exponentially increases the outstanding amount & interest payments. Here, we have assumed that no payments are being made which increases balance overtime. Thus, a person needs to know the interest rates and the period over which it will be charged.
This is an example of credit cards compounding monthly. Some credit card compounds on a daily basis. It is always advisable to pay off your debt and never carry a balance on your credit cards.
Let’s take one more example of debt mount that is Interest on Loan. The interest charged on loans is similar to that of credit cards. But one thing to keep in mind is, people generally tend to go with longer Equated Monthly Installment (EMI’s) while looking for loans. This results in paying more interest and generate more effect of compounding.
Some things that you can keep in mind to avoid the negative effects of compounding are:
Invest your money in an instrument that earns more than the rate of inflation, so the real return is higher.
Pay your loans on time and don’t take loans for a longer period. Always consider paying your debt as soon as you can.
Keeping a check on your finances with the correct measures makes it easier for the compounding to work. It is a great tool if it works in your investments and can be your worst rival when it comes to loans and other debts. Thus, one should keep a proper tab on investments and debt and you will eventually figure out how compounding can work for you.