If you understand the magic of compound interest, and put your money to work accordingly, that is not an impossible feat, says Abhishek Agarwal
How many times you have wanted your money to double magically in your locker? While there is no way to double the money kept in a locker, there is definitely a way to grow it exponentially by compound interest. Albert Einstein considered compound interest as the greatest mathematical discovery. With the help of compounding, anybody can build an enormous wealth in due course.
The best thing is that it does not need you to be a celebrated scientist to understand it. It is a very simple, yet very powerful concept. Every investor can master the miracle of compound interest to grow his or her corpus.
Basic concept of compound interest
Suppose you have invested Rs 10,000 at a simple interest rate of 10 per cent. After a year, your money will earn an interest of Rs 1,000. This way, at the end of 10-year-period your investment will grow to Rs 20,000.
However, if your interest is compounding, the total value of your investment at the end of 10 years will be Rs 25,937.42.
Compound interest is calculated by taking into consideration the accumulated interest. It assumes that the interest you have earned at the end of the year is reinvested, and so earns extra interest for you.
Thus, in the above example, the compound interest earned at the end of first year, i.e., Rs 1,000 will be reinvested. This means that the next year, you will earn interest on an amount of Rs 11,000 instead of Rs 10,000.
The process goes on till the end of the investment term, getting you extra return on your investment.
Mastering the miracle of compound interest
Those who understand the concept of compound interest know that they can use it to their advantage and accumulate large amount of wealth. Here is how you can master the magic.
Start early
The two factors that play the major role in exponentially growing your corpus overtime are time and reinvestment. Therefore, if you wish your investment to grow, you will need to start investing as early as possible.
Ram (25 years), his colleague Anuj (30 years) and their manager Atish (35 years) decided to invest in their retirement fund starting from now. Ram and Anuj started investing Rs 5,000 on a monthly basis at a rate of return of 8 per cent per annum.
Atish started a periodic investment of Rs 7,000 at the same rate of return.
At the age of 59 years, the accumulated wealth of Anuj [his investment was for 29 years: (59 minus 30)] and Atish [his investment was for 24 years: (59 minus 35)] were Rs 65,10,090 and Rs 58,55,406 respectively.
On the other hand the accumulated wealth for Ram was a staggering Rs 99,30,181 [Ram's investment was for 34 years: (59 minus 25)]. You can notice that even while investing more than Ram and Anuj, the accumulated value of Atish's investment was just a little more than half of Ram's wealth because the number of years for which Atish let his investments compound were only 24, compared to Anuj's 29 years and Ram's 34 years.
Hence, the more time you allow your money to compound, the final amount increases accordingly.
Invest regularly
The best part of compounding is that you do not need to invest large amount to build your wealth. Instead, you can invest as low as Rs 1,000 per month on a regular basis to accumulate large amount of wealth.
Make financial goals
The best way to leverage the miracle of compounding is to make financial goals. They can be anything from a comfortable retirement to funding a vacation. Divide your financial goals in short term, medium term and long term. Every month, invest the money to fulfil these goals.
The simple rule of 72
If you find the calculation of compound interest a little cumbersome, you can always take the help of the rule of 72. How long does it take your money to double?
The rule of 72 is a handy formula that will give you the approximate answer. Just take your interest rate and divide 72 by it. So if your interest rate is 10 per cent, your investment will double in around 7.2 years (72 divided by 10).
Similarly, if you earn an interest rate of 12 per cent per annum on your investments, your money will double in just 6 years (72 divided by 12)!
Illustration: Dominic Xavier/Rediff.com
The author is Co-founder and Director Credit Vidya.
