Money cannot buy happiness, but it allows you to fully experience life. However, having a sufficient amount to cater to your present lifestyle is not enough. Hence, the importance of wealth creation becomes paramount. For a well-strategised wealth creation, where you need your savings to grow passively, the timeless principle of compounding is all you need. The potential of compounding encompasses all asset classes, be it equity, debt, real estate, mutual funds, or commodities.
A feasible wealth creation process involves a simple concept of compounding, where returns are generated on your initial investment and accumulated earnings. The compound interest calculator is a very efficient tool for this process.
Calculating Compound Interest:
Here is a simple way to calculate compound interest.
| Details | Data for calculations | Explanations |
| Investment amount | Rs. 1000 | Principal amount |
| Interest you earn | 5 % | Rate of Interest |
| When to calculate interest | Annually | Compounding Frequency |
| Amount after 1st Year | Rs. 1050 | The amount you started the year with 5% interest: 0.05*1000= 50 1000+50= 1050 |
| Amount after 2nd year | Rs.1102.50 | The amount you started the year with along with 5% interest :
0.05*1050= 52.50 1,050 + 52.50 = 1,102.50 |
Hence, the compounding interest formula is P(1 + r/100)n – P Where P is the principal amount, n is the number of years, and r is the interest rate.
The rule of 72 can also be applied here to estimate how many years the invested amount will be doubled. If you divide 72 by the rate of interest or return, you will find the number of years it will take your invested amount to double in value.
If you are not in a number-crunching mood, simply use the compound interest calculator to check the amount you need to invest to gain the desired future value.
Key factors of Compounding :
We need to keep in mind two important factors of compounding to maximise returns :
1. Time:
The longer you stay invested, the better returns you can expect. You need to start as early as possible to encash time to your advantage. Even if the amount is small, if invested for a longer time will give you a substantial accumulation of wealth. It will also help you to inculcate long-term financial discipline which helps you to make further financial decisions with clarity and confidence.
2. Rate of Return:
It is obvious that the higher the rate of return, the impact of compounding will be greater. However, the asset classes you invest in must align with your risk appetite and financial goals. The balance between risk and return is crucial when making any financial decision. A high-risk instrument might promise a greater rate of return but may not be suitable for your financial objective.
Benefits of compounding
The power of compounding is considered the holy grail of financial management. If done with discipline and at the right time, it can help you to accumulate immense wealth over the years.
- It helps in multiplying the principal amount exponentially over time.
- It helps investors to earn returns and further increase return potential in the next compounding cycle.
- It takes comparatively less time to multiply when interest is compounded.
- This power can be harnessed by any financial instrument to increase the return amount.
- It is a simple concept and does not require any specialist to understand and execute.
Top 5 Tips to unleash the power of compounding
These few points will help you maximise the outcome of compounding if followed:
1. Invest Regularly:
Consistent investment is the essence of financial discipline. You need to keep investing at regular intervals, monthly, quarterly, or annually so that you do not lose out on the growth potential that time has to offer. A monthly Systematic Investment Plan is a good example of automating your savings.
2. Choosing the right financial instrument:
Selecting the correct financial instrument is the key to long-term investments. You need to look for instruments that offer compounding benefits like fixed deposits, mutual funds, Public Provident Fund, and Tax saving schemes, not only to align your risk tolerance but also to diversify your portfolio. Check the compound interest calculator for each of these asset classes before choosing a product.
3. Re-invest Dividends and Returns:
Opt for dividend reinvestment or interest re-investment instead of cash out. This will maximise the compounding effect.
4. Compounding Frequency:
Look for instruments that give you options to compound your interest more frequently. Some fixed deposits allow you to opt for compounding monthly and quarterly.
5. Seek Professional Advice:
In case you are unable to devote time to understanding your options, you can seek professional help to customise the portfolio as per your financial situation.
It is important to remember that wealth creation is a journey and compounding is not an overnight solution. It involves patience, understanding, and discipline to succeed.
