Compounding is the process of earning interest on interest over time. This means that the interest you earn is added to the principal, and then the interest is calculated based on the new total. The longer the money is left to compound, the greater the effect becomes.
Let’s understand the concept in detail;
With an array of investment options available, the chances to earn from your money has also gone high. Even investments in small amounts, like SIPs, have the potential to generate a good pool of money over a period of time. However, while we are talking about saving money and earning interest over it, the factor which makes a difference is the method of compounding.
Compounding interest, also known as ‘interest on interest’, refers to the interest accrued on the initial deposit (principal) including all of the accumulated interest.
Equity market as well as several schemes run by the government work on compounding-based interest calculation.
Within the equity market, mutual funds can let you create considerable long-term wealth provided your investment decisions are timely and informed.
How Compounding Works?
For example, let’s say you invest Rs 1,000 in a savings account that earns 5% interest per year. After the first year, you would have earned Rs 50 in interest, bringing your total to Rs 1,050. In the second year, you would earn interest not just on your original Rs 1,000, but also on the additional Rs 50 you earned in interest. So, at the end of the second year, you would have Rs 1,102.50. Over time, this compounding effect can lead to significant growth in your investment.
Compounding works particularly well with long-term investments, such as retirement savings. By starting to save and invest early, and leaving the money to compound over a period of decades, even small contributions can grow to a significant sum.
The amount of interest that you earn on your savings keeps getting added back to the principal, and the interest amount is then calculated on the new principal amount (Original amount + interest earned). Now, since the principal amount keeps growing every year, so does your return. This is the power of compounding.
Simply, compounding means you not only receive the interest on the basic principal amount, but also on the interest that keeps getting added to it.
Many investors in their early days of investment tend to underestimate or ignore the fact that the compounding effect is the prominent accelerator for growing one’s wealth and building a great corpus over a period of time.
Compounding can make you rich by allowing your money to earn interest on interest over time, leading to significant growth in your investments.
Investors must note that any financial decision you make must be based on your own research and consultation with a qualified financial advisor.
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