Compound interest is often referred to as the eighth wonder of the world. As Albert Einstein famously said, “He who understands it, earns it. He who doesn’t, pays it.” But what exactly is compound interest? Simply put, it’s the interest earned on both the initial investment and the accumulated interest over time.
Understanding the basics
Let me explain with a relatable example. Think of how our knowledge evolves. As children, our understanding of the world is limited. However, as we grow, our knowledge compounds—we learn from our experiences and mistakes, building on what we already know. Similarly, when you invest money today, it earns interest each year, and that interest, in turn, generates even more interest, leading to exponential growth.
While many of you might already understand what compound interest is, have you ever wondered why it’s hailed as the eighth wonder of the world? Let’s explore this concept further and discover the extraordinary impact it can have on our investments.
Let us begin with a simple example. Suppose you invest ₹1,000 in an instrument offering a return of 10% per annum. After one year, your investment grows to ₹1,100. In the second year, you earn interest not just on your initial investment of ₹1,000 but on the entire ₹1,100, which grows to ₹1,210. In the third year, you earn interest on ₹1,210, and this compounding effect continues as long as you remain invested.
To give you a clearer picture, here’s an illustration of how your wealth can grow if you invest ₹1,00,000 at an annual return of 12% for a specific number (n) of years. The compounding effect can truly work wonders over time.
· After 30 years, your investment grows to ₹29,95,992.
· After 40 years, your investment skyrockets to ₹93,05,097.
Difference Between Simple and Compound Interest
With simple interest, an investor earns returns only on the principal amount, meaning the interest is calculated solely on the initial investment. In contrast, compound interest allows the investor to earn interest not only on the principal but also on the accumulated interest from previous periods.
Let me illustrate this with an example. Suppose an investor invests ₹1,000 with an expected return of 15%. Here’s how the interest would accumulate in both cases:
Simple Interest: The interest is calculated on the principal of ₹1,000 each year.
Compound Interest: The interest is calculated on the principal as well as the interest earned in the preceding year.
| Years | Simple Interest | Compound Interest |
| 1st | 1,000*15% = 150 | 1,000*15% = 150 |
| 2nd | 1,000*15% = 150 | 1,150*15% = 172.5 |
| 3rd | 1,000*15% = 150 | 1,322.5*15% = 198.37 |
| 4th | 1,000*15% = 150 | 1,520.88*15% = 228.13 |
| Total Interest Earned | 600 | 749 |
By the end of the investment period, you’ll notice that compound interest results in ₹149 more in interest compared to simple interest, demonstrating how compounding significantly enhances returns over time.
How Compounding Helps Your Mutual Fund Investments Grow
We’ve all heard that mutual funds generate wealth over time, but how exactly do they do this for investors? Let’s take a closer look. Imagine you invest ₹5,000 per month in mutual funds through a Systematic Investment Plan (SIP), and your investment grows at a Compound Annual Growth Rate (CAGR) of 12%. Over time, the power of compounding significantly increases the value of your investment.
As demonstrated in the figure above, the longer you stay invested, the more wealth you can accumulate. But it’s important to remember that both the duration of your investment and the rate of return play crucial roles in your wealth creation.
To further illustrate this impact of the rate of return, let’s consider a graph showing how Rs. 10,000 invested over 20 years as a lump-sum amount grows at different annual return rates—5%, 10%, 15%, and 20%.
To further illustrate this impact of the rate of return, let’s consider a graph showing how Rs. 10,000 invested over 20 years as a lump-sum amount grows at different annual return rates—5%, 10%, 15%, and 20%.
This clearly highlights the significant impact of compounding, reinforcing the importance of allocating at least a portion of your investments to equity-related instruments like mutual funds. The higher the return, the more substantial your wealth accumulation over time.
Summing up
The concept of compounding is not just about earning interest on your money—it is about the growth that happens when you let your money work for you. The longer you stay invested and the higher your rate of return, the more your wealth will grow. This is why compounding is often referred to as the eighth wonder of the world—its potential for generating exponential growth is unmatched. So, if you haven’t already, start investing early and let the power of compounding work its magic.
Start your journey with Fincart today and watch your money grow exponentially over time! Reach out for a personalized consultation and discover how compounding can work wonders for your financial future.
