To many, the power of compounding seems like a difficult topic. But it is not so. We’ll help you understand this in a simple manner.
Let us assume that someone invested ₹. 10,000 @ 8% p.a. The interest for the year would be ₹.800. However, when the interest is reinvested in the same investment, the earning next year would accrue on original investment of Rs. 10,000 as well as on the additional investment of ₹.800. This means, the earning for the second year would be ₹. 864. As the years pass, the interest for the year keeps increasing since there is additional investment each year.
How much money would be accumulated after a certain time period if the returns are reinvested? Let us see.
Investment:₹.. 1, 00,000
Rate of return: 8% p.a.
The above table shows some interesting pattern. As the investment is held for longer periods, the earning keeps growing faster. While the earning in the first 5 years was ₹.. 0.47 lacs, the same for the next 5-year period was ₹.. 0.69 lacs (₹.. 2.16 lacs – ₹.. 1.47 lacs). The earning in the 21st year – a single year – was ₹.. 0.37 lacs.
“As the time goes, the earnings do not multiply, but grow exponentially.”
Essentially, compounding is the process of earning income on your principal investment plus the income earned – the income also starts to earn as the same is reinvested.