THE POWER OF COMPOUND INTEREST

THE POWER OF COMPOUND INTEREST

May 24, 2020 0 By Gaurav Varghese
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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.

DaysAmountDaysAmount
110115120
2201210240
3401320480
4801440960
51601581920
632016163840
764017327680
8128018655360
92560191310720
105120202621440

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.

ARs.4,060,588
BRs.1,613,283
CRs.887,016

(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.

 You might need to skip going out for dinner often, avoid buying expensive clothes or buying a new iPhone every year. But the sacrifices are worth it.

Thank you for reading,

Gaurav Varghese

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