THE POWER OF COMPOUND INTEREST
The power of compound interest:
Once Albert Einstein said, “Compound interest is the 8th wonder of the world. He who understands it earns it; he who doesn’t, pays it.”
Compound interest can help you grow your wealth exponentially, it is what made Warren Buffet a billionaire. Most of us know the formula for the compound interest which we have studied in high school and looks like:
[P (1 + i)n] – P
Where P = Principal, i = annual interest rate in percentage and n = number of compounding periods
Compound interest is interest earned on money that was previously earned as interest which leads to increasing interest and account balances at an increasing rate, also known as exponential growth.
But had we ever thought that we will need it in real life?
First, let us consider a hypothetical scenario, imagine you have Rs.10 on the first day of the month and the amount is doubling every day. So, let us see what will be the amount with you on the 20th day of the month.
That is the power of compound interest. Of course, no bank or stock will double your money every day. So, let us consider a real-life situation
Suppose there are three friends A, B and C and each of them started investing at a different age. Let’s say A started investing when he was 25, B started when he was 35, and C started when he turned 40. Each of them invested the same amount for which is Rs.5000 per month at 7% interest compounded annually.
Let’s see what will be the amount they have accumulated by the time they are 50 years old.
(I am not considering the tax deductions here as every country will have their rates.)
You can see that the earlier you start the more wealth you can accumulate. Here time is your friend. The snowball effect is an analogy for compounding. It shows how small amounts can lead to big gains over time.
For most of us, saving Rs.5000 per month at the age of 25 might seem difficult, but if you do, you will end up with a huge amount 25 years later which can help you buy your dream car or your own house.
Thank you for reading,
Gaurav is an MBA Finance student and soon to become a financial planner. He loves to help people and one of the tools he uses to help is writing. He loves to write and read about finance and is a fitness enthusiast the one who never misses his workout. If there’s one strength of his of which I am aware of then that’s Discipline.