The Power of Compounding
Often called the "eighth wonder of the world."
What is Compounding?
Compounding is the process where the earnings from an asset, from either capital appreciation or interest, are reinvested to generate additional earnings over time. This growth, calculated on the initial principal and the accumulated earnings from previous periods, is like a snowball effect for your money.
In simple terms, it's the process of earning returns on your returns. Over a long period, this can lead to exponential growth of your investment, far exceeding what you could achieve with simple interest.
Compounding in Action: A Simple Example
Let's compare Simple Interest vs. Compound Interest on an investment of ₹1,00,000 at 10% p.a.
| Year | Simple Interest Value | Compound Interest Value | Difference |
|---|---|---|---|
| 1 | ₹1,10,000 | ₹1,10,000 | ₹0 |
| 5 | ₹1,50,000 | ₹1,61,051 | ₹11,051 |
| 10 | ₹2,00,000 | ₹2,59,374 | ₹59,374 |
| 20 | ₹3,00,000 | ₹6,72,750 | ₹3,72,750 |
| 30 | ₹4,00,000 | ₹17,44,940 | ₹13,44,940 |
As you can see, the difference becomes dramatically larger over time. This is why starting early is so important.
The Three Levers of Compounding
Time (The Most Powerful Lever)
The longer your money stays invested, the more time it has to compound. Even small amounts can grow into large sums over several decades.
Rate of Return
A higher rate of return will accelerate the compounding process. This is where choosing the right investments (like equity mutual funds for long-term goals) becomes crucial.
Regular Contributions
Consistently adding money to your investments (like through a SIP) adds fuel to the fire, giving the compounding engine more principal to work with.