Power of Compounding: What is it and How Does it Work?

TL;DR

• Compound interest is a type of interest that is calculated on the initial principal of an investment as well as the accumulated interest of previous periods.
• The formula for compound interest is: A = P(1 + r/n)nt, where A is the final amount, P is the initial principal invested, r is the interest rate, n is the number of times interest has been applied per time period, and t is the number of time periods elapsed.
• To earn compound interest, you can either invest a lump sum of money for a long period or periodically invest smaller amounts over a long time. Compounding gives you benefits like faster growth of wealth, higher returns over long periods, etc.
• Compound interest has a snowball effect- over time, a small investment grows significantly by compounding. The longer the investment period, the higher the returns.
• Some key rules to earning compound interest are starting early, not withdrawing returns too early, finding the right investment instruments, etc. Compound interest instruments are available in cryptos as well. Check out Mudrex Vault to know more.

Introduction

You’re probably familiar with the term “compound interest” from your school days. But how much thought have you given to the concept apart from remembering the formula to pass that math test? If it isn’t a lot, it’s probably time that changed. And we’re here to help you achieve financial enlightenment and work towards your financial freedom with the power of compounding.

Albert Einstein is famously known to have said, “Compound interest is the eighth wonder of the world.” And while that might seem like an exaggeration, that quote could not be more true in finance. So without further ado, let’s take a page out of Einstein’s book and gain a better appreciation of the power of compounding.

What Is Power of Compounding?

The power of compounding basically refers to the interest you earn on your previously accumulated interest. Let’s say you invest a certain amount of money, and it earns interest over a month. Through compound interest, you will now earn interest on your initial investment plus the interest it accumulated over the past month! Why don’t we try to understand this with an example?

Example of power of compounding

Say you and your friend, Chandler, decide to invest ₹1,00,000 each in the same stock, and this stock gives you 15% interest annually. You plan to withdraw the interest earned every year, while Chandler’s strategy is to re-invest the interest and add it to the initial investment. Let’s see how this would play out in a ten-year period.

With the power of compounding, Chandler would’ve earned about ₹ 1.5 lakhs more than you in ten years. Now, that’s no chump change. So what we can take away from this little example is– be like Chandler. Use the power of compounding to your advantage!

How did we arrive at these numbers, though? Let’s take a quick look.

How to calculate compound interest

If you’re one of those people who forget formulas right after an exam, no worries. We’ve got your back. Here’s how you calculate compound interest:

A = P(1 + r/n)^nt, where A is the final amount, P is the initial principal invested, r is the interest rate, n is the number of time interest has been applied per time period, and t is the number of time periods elapsed.

If you don’t want to do all this yourself, you could simply use a compound interest calculator that uses the same formula and does the job for you. All you have to do is enter four values into the calculator:

1. Principal amount:

This is the amount you intend to invest

2. Frequency of compounding:

This is the number of times the interest is compounded per time period.

3. Investment period:

This is the number of time periods you intend to invest for. This could be different periods of time, but it is usually calculated in years, as most investments give annual returns.

4. Expected rate of return:

This is the interest rate you expect to receive on your investment. This changes depending on the asset you’re investing in.

Now that we’ve understood how to calculate compound interest, let’s take a look at how the power of compounding applies to your investments.

How Does the Power of Compounding Work in Investments?

When you invest your money, you earn interest on it. In compound interest, you now earn interest on this new amount that includes the interest you previously earned. Long story short, compound interest means that your interest earns you interest.

There are two ways you could go about investing your money to earn compound interest. The first way is to invest a lump sum of money that earns interest over a long period of time. The second way is to periodically invest smaller amounts of money that will add up to a significant amount over time.

Let’s take a look at how the power of compounding works in mutual funds since they’re the “it” thing in investment these days. One reason for this interest in mutual funds is the fact that they take advantage of the power of compounding and generate significant returns over time.

Mutual funds offer a facility called SIP– Systematic Investment Plan, which allows you to invest small amounts of money at pre-defined intervals. These investments go on to grow exponentially over time, offering exponential returns.

Benefits of Compounding in a Long-Term Investment

1. Faster growth

Compound interest allows you to grow your wealth by earning you interest on interest. The initial investment multiplies exponentially over time.

2. Ability to contribute regularly

You can make contributions to your initial investment regularly, allowing your money to grow even faster than it would otherwise.

3. Longer the investment, higher the returns

This one is pretty self-explanatory. The longer you allow your investment to earn interest and compound it over the years, the higher your final returns will be.

4. Uncomplicated to execute

You don’t need to be an expert in the field with extensive knowledge of investments and investment instruments to be able to take advantage of the power of compounding. That said, always DYOR– Do Your Own Research.

How Long Should You Invest to Get the Most Compounding Benefits

The power of compounding works like magic, and we’ve already seen how Chandler took advantage of it to make a small fortune for himself. The only thing is, the power of compounding needs time to work its magic. The longer it has, the better the results are.

When you invest, it is also important to remember that your investment will only give you these exponential results when you re-invest your earnings and add it to your initial investment. Basically, try not to withdraw your profits until the end of your investment period. This allows your interest to compound and grow exponentially. And it’s always best to start investing as early as you can. In case we haven’t said it enough already, the longer you invest your money, the higher your returns will be.

How Can Compounding Benefits Help You Save More?

Have you heard of the snowball effect? If you haven’t, you’re about to. Imagine a snowball rolling down a hill. All those cartoons you watched as a kid should serve as great points of reference. Now, as this snowball rolls further and further down the hill, what happens to it? It grows bigger and bigger.

This is essentially how compounding benefits help you grow your investments. Something that starts off as a small investment grows into a significant amount over time with the power of compounding.

Key Investment Rules That Enable Power of Compounding

The power of compounding doesn’t work without you playing your part. Here are some key rules to follow that will help you compound your returns.

1. Start early

They say the early bird gets the worm. In this case, the early bird gets to make the most of the power of compounding and earn massive profits on their investment. The earlier you invest your money, the longer it has to grow, and the higher your returns will be.

So if you haven’t already started investing, now is the best time.

2. Be patient with your investment

It’s really important to give your investment a reasonable amount of time to grow if you want to see your portfolio thriving. Setting goals is important; it’s just as important to define an appropriate time frame to achieve these goals. You need to be realistic because wealth creation doesn’t happen overnight. It takes patience and discipline.

Where does the discipline come in, you might ask. When your investments grow and you start seeing profits, it’s crucial that you re-invest these profits instead of withdrawing them. Withdrawing the profits will severely lower the growth potential of your investment.

3. Choose shorter intervals of compounding

The power of compounding works best when you go for shorter intervals to receive interest on your investments. You can choose among various compounding frequencies, like daily, monthly, quarterly, bi-annual, or annual.

What difference does this make, though? A big one! The more often your investment compounds, the higher your returns will be.

4. Find the right investment instruments for you

You need to find the instruments with the growth potential that aligns with your goals and time limits. And the importance of diversifying your portfolio cannot be overstated. Try to invest in a variety of asset classes to make sure you aren’t sacrificing liquidity.

Compound Interest Vs Simple Interest

Let’s cut to the chase with this one. Simple interest is the interest received only on the principal amount, i.e., the interest received is not added to the initial amount. We’ve gone over compound interest but let’s reiterate the point. In compound interest, the interest that is received on the principal amount is added to it in the next cycle, thus giving you better returns.

Now, you probably have one burning question.

Which is better, simple or compound interest?

This actually depends on which side you’re on. If you’re an investor, compound interest is the obvious winner as it adds interest on interest, earning you higher returns. On the flip side, if you’re borrowing money, simple interest would work in your favor because you wouldn’t have to pay interest on interest. The interest is only calculated on the principal amount.

Applying the Power of Compound Interest to Crypto

We’ve seen how useful compound interest can be. But what can it do for you if you hold crypto? There are services out there that let you invest your crypto to earn compound interest on it. It works on the same principle, only instead of depositing your INR, you can deposit your cryptocurrencies. How much difference would this make to your portfolio, though? Is it really better than just holding your crypto? Let’s find out.

Say you have 1 BTC in your wallet as we speak. If you held on to this BTC for a year, you’d have 1 BTC at the end of the year, no harm, no foul. Now, if you invested this BTC and if your investment compounded on a monthly basis at an interest rate of 6%, you’d have 1.062 BTC at the end of the year. The larger your initial investment, the higher your final amount will be.

So if you’re looking to earn interest on your crypto investments, check out Mudrex Vault.

Conclusion

It doesn’t matter if you’re holding fiat currency or crypto. Investing to earn compound interest is a no-brainer. So if you haven’t already, what are you waiting for? No better time than the present.

FAQs

1. Is it better to compound interest daily or monthly?

When it comes to compound interest, the more frequent, the better. Always opt for the option with the lowest interval of compounding. So, in this case, the obvious choice is to compound interest daily as it offers better returns.

2. Can compound interest make you rich?

Compound interest can certainly act as a means to create wealth. When you make an investment, it receives compound interest and grows substantially over time. You can even choose to deposit smaller amounts of money regularly, adding to your initial investment if you don’t want to start off with a lump sum.

3. What does compound interest mean?

In compound interest, when your initial investment earns interest, this interest is added to the principal amount during the next cycle. Essentially, you earn interest on interest. This is usually preferred by investors as it offers higher returns on investments.