“Principle of Compounding” is a very powerful tool in Finance and Economics. Compounding in simpler terms means interest being added to the principal, thus the addition of interest to the principal is called compounding. “Principle of Compounding” means that not only the principal amount earns interest but the interest amount also earns interest (interest on interest). Thus it leads accelerated growth of Wealth.
COMPOUNDING IN PERSONAL FINANCE
In “Personal Finance” it is very important to understand the power of compounding as you plan your investment or even when you plan to take a loan. In modern times all the interest calculation is Compounded irrespective of it being a Financial Institution, Bank or any other organization. Hence one has to be careful while borrowing funds with regard to interest, length of repayment and mode of repayment.
However when you borrow money from banks or any financial institution and agree to repay through Equated Monthly Installments (EMI) then you are able to reduce the impact of Compounding to a certain extent.
While investing we do benefit from Compounding of our investment. The tenure of investment determines the quantum of benefit. The longer the period of investment the greater is the return.
SIGNIFICANCE OF COMPOUNDING IN INVESTMENT
Investments are made with a primary objective to earn good returns on them. But the quantum of return depends on various other issues as well, i.e, Nature of Investment, Tenure and etc.
Principle of Compounding plays a pivotal role in the growth of investment. The longer the duration of investment the greater is the return. Here investment period is more important than the investment itself. It lays foundation to the concept of Time Value of Money, which states that value of money changes with respect to time.
EARLY INVESTMENT+ LONG TERM INVESTMENT= HUGE RETURNS
Individuals who start investing early and continue for long term benefit more as compared to ones who start investing late.
Let’s look at the Illustration:-
Compound Interest = Total Amount (Principal +Interest) – Principal Invested
[P (1 + i)n] – P
Where, P= Principal Amount, i= Interest, n = Number of Years.
- Mr.A invested Rs 60,000/- ($ 1000) @ 8% for 25 years.
- Mr.B invested Rs 1,20,000/- ($ 2000) @ 8% for 15 years.
After completion of stipulated period:-
Mr.A will accumulate Rs 4,10,908/- ($ 6627) approx.
Mr.B will accumulate Rs 3,80,660/- ($ 6139) approx.
Hence we find smaller amount invested over a longer period earns more return as compared to large sum invested over a shorter duration.
INVEST EARLY AND FOR LONGER TENURE
Thus every individual needs to plan his investment early and choose longer investing period in order to reap the benefits of “Power of Compounding.