What Are The Benefits of Compounding Money?

What is Compound Interest?

When you deposit your money in the bank, you earn interest. Say you deposited Rs.50,000 for three years at 10% interest, i.e. at an interest of Rs. 5,000 per year. At maturity, after 3 years, you will get Rs.65,000 (50000+15000 interest). This is the concept of simple interest, a percentage of the original amount (principal sum) given as a reward for depositing the money. Now, take this up a notch.

Say you never withdrew the interest amount and reinvested it every year. So, at the end of the first year, when you get Rs.5000 interest, you reinvest it. For the second year, the principal becomes Rs.55,000, and you get 10% interest on this sum, which is Rs.5,500. Again, instead of withdrawing it, you decide to reinvest it. So, for the third year, the principal becomes Rs.60,500, and 10% interest on this comes to Rs.6,050. The total interest at the end of three years is thus Rs.16,550, and you get Rs.66,550 on maturity. This is compound interest.

Compound interest allows you to earn interest on your previously earned interest. The example we saw was only a small-scale sum over a short time. But, the longer you stay invested, the more you get the benefits of compounding. The key to maximizing compounding is to start early and keep investing regularly. Doing so allows your investments to grow at an increasing rate, leading to substantial gains over the long term.

How Compounding Affects Your Investment In The Longer Run?

Compounding allows your investment to grow over time, with each cycle adding to the previous earnings. Here’s an example of how compounding can boost your investments over different periods:

Suppose you invest Rs.1,00,000 annually for 15 years in an investment that gives you 10% returns compounded annually. Your corpus will look like this

Year	Opening Balance (Rs)	Investment (Rs)	10% Interest (per annum)	Closing Balance (Rs)
1st	–	1,00,000	10,000	1,10,000
2nd	1,10,000	1,00,000	21,000	2,31,000
3rd	2,31,000	1,00,000	33,100	3,64,100
4th	3,64,100	1,00,000	46,410	5,10,510
5th	5,10,510	1,00,000	61,051	6,71,561
6th	6,71,561	1,00,000	76,156	8,47,717
7th	8,47,717	1,00,000	92,772	10,40,489
8th	10,40,489	1,00,000	1,10,049	12,50,538
9th	12,50,538	1,00,000	1,28,054	14,78,593
10th	14,78,593	1,00,000	1,46,859	17,25,452
11th	17,25,452	1,00,000	1,66,545	19,91,997
12th	19,91,997	1,00,000	1,87,200	22,79,197
13th	22,79,197	1,00,000	2,08,920	25,88,117
14th	25,88,117	1,00,000	2,31,811	29,19,928
15th	29,19,928	1,00,000	2,55,993	32,75,921

Over 15 years, your total investment of Rs.15,00,000 grows to Rs.32,75,921. The difference of Rs.17,75,921 is your total capital gains earned through compounding. Without compounding, your interest on Rs.15,00,000 collected over the years would be Rs.1,50,000. You can also learn your average yearly return by calculating CAGR (Compounded Annual Growth Rate). 

When looking for investments that offer similar growth opportunities, you can opt for safe-compounding and high-risk instruments depending on your risk appetite, financial goals, and investment horizon. The investment avenues include (but are not limited to) the Public Provident Fund (PPF), Equity-Linked Savings Scheme (ELSS), Fixed Deposits, Equity Mutual Funds, and Life Insurance Savings Plans. 

Compounding in itself does ensure good growth. However, there is a scope for maximizing your returns using specific strategies. 

Strategies to Maximise Benefits of Compounding Money:

• Start investing early and regularly. The sooner you begin, the more time your money has to grow. Time is crucial in compounding, so even small early investments can grow significantly. Regular monthly or quarterly contributions boost this effect by steadily increasing your principal amount.
• Reinvest dividends and capital gains. When you earn dividends or capital gains from stocks or mutual funds, reinvesting them instead of withdrawing adds to your principal. This amplifies the compounding effect, leading to greater overall returns over time.
• Choose investments with high growth potential. Stocks or mutual funds with solid growth prospects can accelerate the compounding process. However, it’s essential to thoroughly research and choose investments that align with your financial profile.
• Be mindful of the inflation rate when choosing your investments. If the inflation rate is 6%, your investment earns 8%. Primafacie, your returns are 8%, but after factoring in the inflation rate, the actual return will be just 2%. So, choose investments that beat inflation to protect your wealth in the long run.

Combining these strategies can create a compounding snowball effect only when you allow your investment to grow patiently. Compounding is all about time, so stay committed to the process.

Benefits of Compounding Money:

• Long-term gains:

The longer your savings compound, the more wealth you can build. Starting as early as possible allows you to maximize the benefits of compound interest, making it a smart strategy for long-term financial growth.

• Reduce risk: 

Compounding with a long-term investment horizon can reduce the risk of short-term market volatility. Even if your investments face dips, the overall growth from compounding can smooth out returns and lessen the impact of temporary setbacks.

• Promotes Planning:  

Knowing the power of compound interest encourages you to save regularly and think long-term to reach your financial goals more efficiently.

• Passive Income:

Compounding can turn your investments into passive income, as the interest earned generates more interest without extra effort. For example, a well-diversified portfolio that compounds interest can deliver a steady income stream during retirement, reducing the need for active management or more contributions.

• Tackling Inflation:

Compound interest also helps your investments outpace inflation, preserving your money’s purchasing power over time. 

• Exponential Growth:

Compounding lets your investments grow exponentially as your interest starts earning interest itself. This results in a snowball effect, where your investment grows faster.

Conclusion:

Compound interest and compounding can boost your savings and retirement potential. Compounding means you use less money to reach your financial goals when done right. But remember, compounding can also work against you, especially with high-interest credit card debt that grows over time. That’s why it’s crucial to pay off debts quickly and start saving and investing early. This way, you make compounding work for you, not against you. Moreover, to make it work best, you can also consult a registered share market advisory.

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