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Early Investing and the Power of Compounding

Power of Compounding is a great way to get good benefits. Read more about investment planning and the power of compounding to get high returns.

  • 10,549 Views | Updated on: May 10, 2024

As children in school, we often had to calculate maths sums regarding simple interest and compound interest. What seemed like simple formulae a long time ago could actually help us a lot in our adult lives. As we grow up and join the workforce, we start to earn some money, most of which we blow on partying, good food, and date nights. As we grow a little older and have a few more responsibilities, we start to think about financial planning. Sadly, by this point, it’s already too late for us to harness the power of compounding.

Power of compounding formula

Compounding is the annual reinvestment of earnings at the same rate of return to growing the principal amount. Compounding is an intriguing notion. This is due to the fact that the interest on your invested funds is also collecting interest. This is referred to as compound interest. The investment’s value grows at a geometric rate (constantly increasing) rather than an arithmetic rate (straight-line). Reinvesting earnings at the same compound interest rate of return would aid in the growth of the principle year after year.

Compound interest is used when the principal includes the accrued interest from prior periods, and interest is calculated on this. Investors can use this strong tool (compound interest) to plan their financial goals. This method will help the investor in the long run. The longer the investment horizon, the bigger the returns. The best advice is to start saving and investing regularly. An early start would provide the investor with a greater compounding effect, making wealth creation easier. Compound interest has many applications. Compound interest only increases returns over time, and the investment rises exponentially.

What is the Power of a Compounding Calculator?

Compounding is the process through which the returns on an investment are reinvested to generate further revenues over time. In a nutshell, compounding is interest on interest, which magnifies rewards over time. This notion is used by the power of compounding to evaluate the worth of an investment.

The Power of Compounding calculator is a tool for determining the value of an investment. It computes the value of an investment after ‘n’ years at a certain interest rate. The compound interest formula serves as the foundation for the power of the compounding calculator. The entire notion of compound interest centres upon earning significant returns by compounding the interest earned on the principal amount.

In the power of compounding calculator, the compound interest formula is:

P [((1 + i)^n) – 1]

Where,

P is the principal

I is the annual interest, and

n is the number of periods.

The calculator assists in determining how much an individual will earn if they invest a set amount for a set period of time at a fixed annual rate of interest. This calculator can be used to calculate the possible returns on investment. They can learn how much their money will grow if they invest them.

What is compounding in financial terms, and How does it work

Generally speaking, compounding refers to the simple concept of earning returns on a return. This means that the longer we invest the more money we will accumulate. Let’s assume you’ve invested ₹5,000 at an interest rate of 5%, to be compounded annually. In the first year, you will earn ₹250. This will be added to your principal amount the next year. So even without you adding any more money, your investment amount in the second year is ₹5,250. At the end of the year, you will earn 5% on the new amount, and so on and so forth.

When it comes to investment planning, compounding is definitely the way to go. It allows you to build up a large corpus of funds. However, there is one important factor that you need to consider. For compounding to work for you, you need to have time on your side. We can illustrate this better with the help of an example.

Power of compounding with example

Suman and Sagar both joined a new firm recently. They’ve been hired at the same level, so they both earn a monthly salary of ₹50,000 per month. While Suman tends to spend almost her entire salary every month, Sagar is a bit more prudent, and he invests ₹3,000 every month in a compounding fund for 5 years. At the end of his investment plan, Sagar would have accumulated ₹2,52,909.

Sagar

Monthly Investment (₹)

3,000

Assumed rate of return (Compound Annual Growth Rate - CAGR)

12%

Investment timeline (months)

60

Ending Investment Value(₹)

2,52,909

After seeing her friend do so well, Suman also decides to start investing in the same way as Sagar. Unfortunately, she started 2 years after him. Despite the fact that she invests the same amount, Suman will end up accumulating only ₹1,34,815 at the end of 3 years. Suman would have lost ₹1,18,094 simply because she started 2 years too late. Apart from missing out on the returns she would have accumulated for the time period, she also missed out on the opportunity to reinvest those returns into her investment and thereby earn more.

Sagar

Suman

Monthly Investment (₹)

3,000

3,000

Assumed rates of return (Compound Annual Growth Rate - CAGR)

12%

12%

Investment timeline (months)

60

36

Ending Investment Value (₹)

2,52,909

1,34,815

The mistake Suman made of starting 2 years later cost her (₹)

1,18,094

In order to play catch up, let’s assume that Suman starts to invest ₹4,000 per month instead of ₹3,000. Let’s see how much of a difference that would make.

Sagar

Suman

Monthly Investment (₹)

3,000

4,000

Assumed rates of return (Compound Annual Growth Rate - CAGR)

12%

12%

Investment timeline (months)

60

36

Ending Investment Value (₹)

2,52,909

1,79,754

The mistake Suman made of starting 2 years later cost her (Rs)

73,155

Despite increasing her initial investment amount, Suman still fails to earn as much as Sagar.

The importance of time during early investing

What we’ve learnt from the above example is that no investment can ever make up for the time lost. Even the smallest of delays can stop you from using the power of compound interest. When Suman started investing just 2 years after Sagar, she ended up with ₹1,18,094 less than Sagar at the end of the investment term.

Long-term saving options provide the power of compounding

If you’d like to utilise the full potential of compounding investments, you can think about putting your savings in fixed deposits, life insurance, and mutual fund schemes. If you’d like to understand how much money you can expect to earn at the end of your stipulated tenure, you could use a power of compounding calculator, which can be found online. Please remember, all investments inherently have some amount of risk, so you’d need to educate yourself about all the risks involved before finally putting your money down.

Public Provident Fund (PPF)

Among all investment possibilities in India, this is one of the most secure long-term investment options. It is exempt from taxation. A PPF account can be established at any bank or post office. The money invested is locked in for 15 years. Furthermore, you can receive compound interest on your amassed funds with this investing choice. You have the option of extending the time frame for the next five years. The sole disadvantage of holding a PPF account is that you cannot withdraw the invested funds until the conclusion of the sixth year. If you require funds, you can borrow against the balance of your PPF account.

National Savings Certificate

NSC is a popular government-backed saving option that offers guaranteed returns as well as tax benefits. NSC is a safe investment that may be made at any post office for a period of five years. The government sets the interest rates on NSC, which are revised every quarter. However, once your investment is made, the interest rate does not alter during the tenure of the NSC. Currently, your investment in NSC yields 6.80% compounded every six months.

A minimum investment of ₹500 is permitted in NSC, with no upper limit. The best part is that you can deduct taxes up to a limit of ₹1,50,000 under Section 80C. Remember that the interest generated on NSC is taxable; thus, when filing your taxes, you must include the interest earned on NSC in your overall income.

Post Office Monthly Income Scheme

The Post Office Monthly Income Scheme, as the name suggests, is a scheme that allows you to save money on a monthly basis and is governed by Post Offices in India. A government-backed initiative that allows consumers to save money every month. Any Indian person can easily register a Post-office MIS account with a minimal deposit of ₹1500. The maturity time of the scheme, which is 5 years, begins the day the account is opened. Investors can open a POMIS account either individually or collectively. Any investor searching for a tax-saving alternative should avoid this tool because it does not provide any tax rebate, either on the maturity amount or the investment amount.

The golden rule of making a wise investment is to have a thorough awareness of the many sorts of investment possibilities accessible in the market. Most investors’ investment goals differ depending on their financial objectives, time horizon, and risk tolerance, among other factors. To make money grow, an individual must invest in clever investment options that can provide lucrative long-term returns.

Also, as an investor, you must distinguish between savings and investment. While saving is regarded as an aloof strategy of wealth accumulation, great investment tactics can help you create more wealth.

- A Consumer Education Initiative series by Kotak Life

Amit Raje
Written By :
Amit Raje

Amit Raje is an experienced marketer who has worked in various Fintechs and leading Financial companies in India. With focused experience in Digital, Amit has pioneered multiple digital commerce in India. Now, close to two decades later, he is the vice president and head of the D2C business department. He masters the skill of strategic management, also being certified in it from IIMA. He has challenged his challenges and contributed his efforts in this journey of digital transformation.

Amit Raje
Reviewed By :
Prasad Pimple

Prasad Pimple has a decade-long experience in the Life insurance sector and as EVP, Kotak Life heads Digital Business. He is responsible for developing user friendly product journeys, creating consumer awareness and helping consumers in identifying need for life insurance solutions. He has 20+ years of experience in creating and building business verticals across Insurance, Telecom and Banking sectors

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