In this world, almost every single person wants to make quick money. There are only two ways to make quick money – either build your own business or you have any extraordinary talent. Talent helps you to make quick money. But not everyone can build own business and also not everyone can easily understand their talent. Most of the peoples are doing a job and in the job, there is the only way to make huge money. That only way is not a quick way but if you have patience you can make huge money. That way is “Power of Compounding” or “Compound Interest”
We all learn compound interest in school. But we never apply to our life. We don’t know how to apply compound interest in making money.
The great Albert Einstein once said, “compound interest is the eighth wonder of the world. He, who understands it, earns it. He, who doesn’t, pays it”.
Now, let’s understand the power of compounding step-by-step.
WHAT IS POWER OF COMPOUNDING?
The power of compounding is a kind of theory that helps your money to grow at a very faster rate. For long term investors, compounding power plays a vital role. Power of compounding depends upon mainly two factors:
- Rate of Return
- Holding Period
Compound interest helps invested money to grow exponentially if held for longer period of time.
If we invest money with a low rate of return and for a low holding period it will multiply invested money slowly.
If we invest money with high returns and for a long holding period it will multiply invested money faster.
See the below table and chart for better understanding:
The above table and graph clearly show that with investing of ₹1,000/- @ 18% rate of return, it took 16 years to reach ₹14,129/-. But it grows like a snowball in last 8 years to reach ₹53109/-. It adds almost ₹38,980/-. This clears that long term investment with a high rate of return multiplies your fund’s very faster rate.
The ₹1,000 investment @ 18% return rate gives you ₹53,109 after 24 years. This is the real power of compounding.
Let’s suppose if you won’t invest ₹1,000 and put it into a bank account. What will happen with this amount, either this amount gets spent or it continues to be ₹1,000 even after 24 years.
POWER OF COMPOUNDING AND TIME VALUE OF MONEY
I know you are now amazed to see the power of compounding. What it can do to our money, we actually don’t know all those years.
The concept of compounding is the foundation of the time value of money. We all know that the value of money in the future is coming down due to many factors. The major factor is the country’s inflation rate.
1Kg apple which was purchased @ ₹30/kg, now its purchasing value is ₹80/Kg.
Whenever the country’s inflation rate increases the purchasing power of money decreases.
There is a theory that says, “A dollar of today is worth more than a dollar of tomorrow”.
Let’s understand with an example.
Suppose the country’s inflation rate for the next 5 years is 4.5%.
You have deposited ₹10,000 in fixed deposits (FD) at 7%. The expected amount after 5years is ₹14,226. This amount is actually on paper.
But the actual value is ₹11,314.
How this is possible?
Actually inflation rate always deteriorates the value of money. The expected amount was ₹14,226 but due to the inflation rate, the actual value of ₹14,226 equals ₹11,314. Because we have to deduct the inflation rate from the rate of return.
So it is always better to invest your amount with good investment tools. Where we can get good returns and use the power of compounding. [Read also: Best Income Generating Assets]
MAGIC “RULE OF 72” TO DOUBLE YOUR MONEY
We all have a wish to double our money as quickly as possible. Because we have our desire to make money quickly. But to double our money we have to understand the Magic Rule of 72.
The majority of peoples don’t know about Rule of 72. If you learn the compounding power than it is necessary to understand this rule. Rule of 72 also depends upon two factors like compounding power:
- Rate of Return
- Holding Period
If we multiply these two factors and the result comes out to be 72 it means our money is going to double.
Further examples are:
It will take 12 years to get your invested money double @ 6% rate of return i.e. 12 x 6 =72.
Assume your investment got double in 5 years. It means that invested money get a 14.4 % rate of return per annum. i.e. 5 X 14.4 = 72
If any agent will tell you to double your money you must check Rule of 72. If holding period & rate of return multiply and result equal to 72 than that scheme is Ok for doubling the money. Otherwise, your agent is taking advantage of your financial illiteracy. [Check: Are you financially educated?]
COMPOUND INTEREST FORMULA
The ‘present value’ and ‘future value’ of money can be calculated with a mathematical formula. We have learned this in our school.
This helps us to calculate the future and present value for our investments.
Suppose ₹1,000 invested @15% rate of return per annum. What will be its future value after 10 years?
FV = 1000 x (1+15%) ^10 = ₹4,046
You can also calculate future value from below calculator.
The power of compounding can only help you when you are having patience. Compounding is a game of patience. You can’t see the results overnight. In fact, compounding power is actually pretty boring. It can be like watching paint dry.
But the results are fascinating. The speed of compounding returns on our investments become faster in later years.
The power of compounding teaches us “Investment is a necessity, it is not an option”.