Compounding is your friend

Compounding is your friend,   Yes !!   you read it correct.   This holds could true always when you are investing, but  this friend becomes enemy in case of credit card debt / loans.

In financial word,  simple interest means,  interest  on principle per year.

e.g.   10% on 1000  for 3 years

1st year  interest is 100
2nd year interest is 100
3rd year  interest is 100
Total interest earned over 3 years is 100 + 100 + 100 = 300
Amount at the end of 3rd year is  principle (1000) plus interest (300) = 1300

Where as in case of compound interest, 1st year interest is calculated in similar way as simple interest. For the 2nd year,  interest is calculated over  principle plus 1st year interest.  That means, you get interest not only on principle but also on 1st year interest. For 3rd year, you get interest on principle plus interest over the interest earned till that year.

e.g.   10% on 1000 for  3 years compounded annually

1st year interest is 100 and amount at the end of 1st year is  1000 + 100 = 1100
2nd year interest will be calculated over 1100
      i.e.    1100 * 10/100 =  110
Amount at the end of 2nd year is  = 1100 + 110  = 1210
3rd year interest will be calculated over 1210
    i.e.  1210 * 10/100 =  121
Amount at the end of 3 year is  = 1210  + 121 = 1331

Compared to simple interest, compound interest gives you  additional amount of 31.   This  amount looks very small in today's terms, but when you consider duration (long term) and rate of return which determine the end result is unbelievably true.   Below table gives some idea of returns on 1000 rupees invested. No. of years is shown horizontally where as rate of return is shown vertically.  It is obvious that higher the  rate of interest, returns are high.  The longer the investment stays in compounding mode, the returns are high.  If you take advantage of both i.e. duration and rate of interest, the returns are "double" high.

In the above example of 1000 invested for 3 years,  the absolute percentage return after  3 years is 30% (Simple interest method) and  33.1% (Compound interest method).  Sometimes, people get amused seeing things in percentages when returns are considered.  Same table is shown below in terms of absolute percentage return.  

For all those who likes  visuals, same thing is shown in graphical format below.  Pay attention to the gap between consecutive lines.  It widens more as as duration increases as well as rate of interest increases.  That means, more returns. 

Remember, above example is shown just for investing 1000/-  "one time" in compounding method channel.  Imagine, you inculcate a good habit of investing regularly via SIP (Systematic Investment Plan), how beautiful is the end result !   

As I mentioned in the starting of the article,  this compounding friend becomes enemy in case of loans/ credit card debt.  In case of investment, what you get is incremented at faster pace over the years; where as in case of credit card debt, you are charged more as you delay the payment (duration) and the debt will grow at faster pace.  Just visualize the above tables and graphs as what you have to pay instead of earning.  You are already getting scared.  Aren't you?

Rate of interest may not be in your control due to various economic and market conditions. However,  duration is in your control.  Start investing "early" and stay invested "longer" period time to get the help of your friend "Compounding"

Happy Investing and leverage compounding.