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Power of Compounding - Compound Interest Calculator
There are only two magical powers in this world, as professed by the most intelligent people to walk the earth – nuclear power and power of compounding.
Compounding interest is the magical power that grows your invested money into wealth over time. Almost every investment instrument can offer a compounding rate of interest. Most of the investment plans starting from bank FDs to ULIPs offer a compounding rate of interest (ROIs).
If you want to compare two investments with similar ROIs, you should pay attention to their compounding rate. It is this compounding interest that can enable you to move higher on the prosperity scale with the help of savings and investments.
Without the compounding, the world of the investment may even lose its charm altogether, as the financial growth will then become linear instead of exponential.
Use this compounding interest calculator to find how your money will grow at different compounding rates and time.
What is the Power of Compounding?
Power of compounding has two jargons in it. The first one, ‘Power,’ refers to the number by which your investment interest is compounded. ‘Compounding,’ on the other hand, refers to the act of reinvesting the earnings of a previous investment.
So, when an investment declares compounded interest, it means it will continue to reinvest the earnings on your original investment until maturity or withdrawal.
In the world of investments compounding is the factor that enables investors to accumulate wealth faster than they can earn it through income. It is also the reason why it is important for everyone to invest money so that one day they can relax and enjoy the fruits of their investments.
Mathematically, the power of compounding is represented in the formula:
In the compounded growth equation, the ‘(1+i)’ represents reinvestment of the interest earned on the invested money ‘P’. Meanwhile, ‘n’ represents the number of times the interest would be reinvested and will itself earn more interest.
How Does Power of Compounding Work?
The power of compounding means you are reinvesting some of your earnings back into the small investment you made earlier. For example, imagine you are starting a trading business where you purchase a specific type of wood at Rs. 10 apiece and can sell it for Rs. 12 apiece.
You had Rs. 1000 to start with and thus, you bought 100 pieces of this wood. Once your stock is over, you will have Rs. 1200 in your pocket. Now, when you go back to purchase a new lot of wood, you can buy 120 pieces instead of just 100. Provided you are willing to reinvest all of your earnings.
If you did purchase 120 pieces of the same wood the second time, you should end up with Rs. 1440 after selling off the second lot. Thus, with just two compounding runs you converted your Rs 1000 to Rs. 1440.
Figure: Reinvesting your earnings to increase your next earning
Continuing your wood trade would have your income doubled in just four cycles. The only challenge for you in reinvesting your earnings for the next trade is the time it takes for you to complete the cycle.
More Compounding Means More Growth
Consider that you and your closest competitor are involved in the same trade. Both of you started at the same time with the same amount of money.
However, it takes you five days to clear your stock, while your competitor takes seven. You would’ve doubled your money in just about 20 days while your competitor will take 28 days to achieve the same wealth.
If you want to invest for a comfortable retirement, start early. Such saving and investment schemes are a great option when you start investing at an early age. Thus, you can also say that the more compounding you have within a given period, the higher your growth can be.
Here are 5 essential investment options for a comfortable retirement.
How Does Power of Compounding Work in Real Investments?
Different investments use different power of compounding. For example, bank fixed deposits are usually compounded quarterly. Interest in PPF and many post office schemes are compounded annually. However, in any case, the rate of interest is represented annually for every investment.
Two factors may play a role in defining the power of compounding for an investment:
1. Accounting principles2. Interest credit
For example, banks maintain their books quarterly, thus, all the interest is credited and reinvested on the fixed deposit money quarterly. However, corporates may declare dividends only once a year. Thus, the compounding on investments dependent on corporate stocks will have annual compounding.
Using Power of Compounding Numbers in Real Life
Any saving plan offering a return on your invested money would try to give you a compounding rate of interest. Even if tentative, this is a reference quantity you can compare with other investment options and make a qualified decision.
The most popular compounding rate is the annual compounding rate. This rate of return is also referred to as Compounded Annual Growth Rate or CAGR. CAGR is an estimated compounded rate of return. Meaning, you converted your absolute returns from an investment into a number which you can draw parallels with similar other investments.
For example, if you have the following two investment results:
1. Bank FD giving 7.5% p.a. compounded quarterly on a 7-year deposit2. Mutual Fund investment returning Rs. 75 for every Rs. 100 invested 7 years ago.
You cannot compare both investments unless you bring them to a common ground, i.e., either convert FD return to an absolute value, or convert the mutual fund’s 75% in 7 years to an annual rate of return.
- If you convert the FD return to absolute value, you will receive approx. Rs. 168 after 7 years (the compounding is quarterly)
- Convert 75% absolute return to an annually compounded rate of return and you get 8.32% p.a. which is higher than FD
6 Benefits of Using a Power of Compounding Calculator
The power of compounding calculations is not as straightforward as other simple mathematics estimates. However, using the calculator you can have the following benefits:
1. Calculations Made Easy
The power of compounding calculator is simple to use. You can select the values for different parameters and the calculator will do the rest for you.
2. Helps Plan your Money & Future
It helps if you know how much money you will need and when. Or have answers to the questions like, if I invest this much at this rate how much money I will have in a few years. If you are planning to invest in a savings plan, you must know how much money you will be getting at the end of the policy term.
Know if saving plans are a good investment choice for you.
3. Compare Different Investment Options
You can use the rate of return and other parameters from the investments you are considering and estimate the future values of your investment.
4. Create and Draw Conclusions from Scenarios
The power of compounding calculator is a very flexible and easy tool to work with. Thus, creating multiple investment scenarios and giving wings to your imagination is not a difficult task.
5. Improve your Savings
The power of compounding calculator can really motivate you to save and invest more. When you see how a small amount of money invested for the right amount of time can turn into a huge sum, you are unlikely to ignore the temptation to save more.
6. Completely Free of Cost
The best part of the calculator is, perhaps, the cost of using it. It virtually nothing, even time is a nominal investment when you are using it, as the calculations take only a fraction of a second to complete.
How to Improve your Savings with the Power of Compounding?
Look at each parameter in the compounding equation. Which ones do you feel are really in your control, and to what extent?
The compounding interest equation contains the following parameters:
Principal amount (P): Amount of money you invested after saving from your income
Rate of interest (i): Offered by the investment depending on the expected market performance
Number of compounding (n): Depends on the tenure of investment or the number of years you will stay invested
The principal amount which is the original invested money depends on the amount of money you save, which in turn is dependent on your income and expenses. Thus, you can only save an amount equal to your income if you are to save the maximum amount.
However, you will also need to run your household, so the savings will almost always be lower than your income. Your, income depends on your employment or business situation. Thus, the principal is in your control only to the extent of your income and expenses.
Since you cannot dictate the rate of interest for any investment, the only thing left in your hand is the number of compounding, i.e., time.
Time is More Important
Time is even more important than the amount of your investment. Even if you start small, staying invested long enough will easily put you ahead of larger short-term investors.
Consider the following example, where two friends who have an identical financial situation, end up with completely different financial results:
- Ram starts investing Rs. 5000 p.m. at the age of 30 and continues till the age of 60
- Shyam only starts investing at the of 46 but invests Rs. 10,000 p.m. He will also continue to invest till the age of 60
If both will earn a rate of interest of 8% p.a., who do you think should have more money at the age of 60?
(Use the calculator to find out)
Understand how saving at an early age of life will help you during retirement.
Key Rules of Investment that Enable Power of Compounding
- Start Today: Rs. 100 invested today could be greater than Rs. 200 invested five years later
- The Habit of Investing: Investing is a habit you need to develop, Rs. 100 p.m. would go a long way in building wealth than Rs. 1000 invested once in a few years
- Time is Most Important: Time is the greatest influencer of compounding growth in investments. So, unless it’s an emergency you should let the investments grow without disturbance.
- Compounding Interval: Pay attention to the compounding intervals (compounded quarterly or annually), especially if you are a safe investor. More frequent compounding is often better than lower frequencies.
||When Compounding is Annual
||When Compounding is Quarterly
|Growth of Rs 100 in 7 years at 7.5% p.a. rate of interest
The chart shows the value of your investments when you invest a fixed amount every year, vs when you increase the investment by 2% every year.
- Keep Up the Investments: Your income defines your lifestyle and financial goals. So, it is only reasonable that your investments too, keep up with the growth in your income.
Power of compounding refers to the number of times the interest earned on an investment is reinvested at the same rate of return. It is the factor that determines the number of times the interest multiplies in the investment.
In a philosophical sense, the power of compounding also means the quality of compounding returns to provide exponential growth to your investments.
Purchasing power determines the value of any amount of money at a given time. For example, you can buy 5 grams of 24 karat gold for Rs. 25,000 now, but in five years you will only get about 4.5 grams. That is because of the rise in the gold price.
The general rise in the price of daily use commodities is called inflation. This inflation causes the value of money to decline gradually. Usually, the rate of inflation is indicated as an annual percentage. For example, the inflation rate in India for the year 2020 was 6.2%.
Meaning the purchasing power of Rs 100 you had in your pocket at the beginning of the year diminished by Rs 6.2 by the end of the year.
So, if the average annual inflation rate is 5% p.a. Rs. 25,000 will be worth Rs. 9422 in 20 years.
When you invest money, your money grows by the rate of return provided by the investment instruments. For example, when you invest in a bank FD, you receive the interest as provided by the FD for the selected tenure. Say, a 5-year FD offers a 7.5% p.a. quarterly compounded rate of interest on deposits.
Thus, the power of compounding in this FD will be 5, for the annual return and 4 within a year due to quarterly reinvested returns.
In total, the power of compounding will be 20, i.e., invested money will with compounded 20 times in five years.
Compounding power reflects the reinvestment of interest. Thus, you can use the power of compounding to estimate the interest factor for the investment period. For example, the rate of return on an investment is 7% p.a. If you invest money in this investment option for 10 years, your interest factor would be “1.07^(10)” or 1.967.
This means every Re 1 invested in this option will grow to Rs 1.967 in 10 years.
Simply invest the money in instruments that offer a rate of return higher than inflation to meet your investment goals. This will ensure the real growth of your wealth in terms of purchasing power. Meaning your wealth will enable you to buy more assets in the future.
Once your invested money is generating annual returns which are higher than your cost of living in absolute terms, you have a unique situation where your wealth starts to compound. For example, if your investments generate Rs. 10 lakhs in a year while you only spend Rs. 5 lakhs, the remaining Rs 5 lakhs will be reinvested.
The reinvested money will increase your return on investment for the next year, officially increasing your wealth without additional investment from you.
If you look at running business stocks will compound only when earnings are declared and a part of it is reinvested in the company’s growth. Which may happen quarterly or annually. So far companies review their books and estimate earnings only quarterly, thus the stocks can be said to compound quarterly.
Compound interest has no disadvantages except in the following two scenarios:
- Difficult to calculate without calculators
- When interest rate is negative, such as inflation rate
In the first case, the estimation of the change at a compounded rate is difficult for manual calculation, because you will need to use complex estimates.
In the case of a negative interest rate, you end up losing money after investment, and since the rate is compounded, the loss is exponential.
Anytime, compound interest means that even your interest starts earning interest after a period. Simple interest on the other hand only accumulates interest but the underlying investment remains the same.
Thus, no matter how long you stay invested, your return on investment will remain the same at a simple rate of interest. However, with compounded interest, your return in the next period will be higher than the previous ones.
Compound interest is considered a powerful concept because you only need to initiate your investment and the rest happens automatically. Imagine your business running itself without your intervention and even start growing itself.
Compound interest can ensure that after crossing a threshold your wealth continues to grow even without additional investment from you. Financial planners call this the stage of financial freedom.
Your money starts generating money for you at this stage. So, you do not really need to work for money anymore.
The most benefit goes to the investors. However, almost every link in the value chain benefits from compound interest. For example, understand that compounding occurs when business income is reinvested into the business for growth.
Thus, compounding helps the business expand its footprint, serve more customers, employ more workers, and grow the value of investors’ money.
Terms & Conditions
This calculation is generated on the basis of the information provided and is for assistance only. And is not intended to be and must not alone be taken as the basis for an investment decisionThe calculations mentioned above take into consideration an assumed rate of inflation of 8%. #The current costs of education mentioned above are approximate values. The end value displayed is on the basis of the information provided and is for assistance only. It is not intended to be and must not alone be taken as the basis for an investment decision. *A 30 years old healthy male can start the plan with a premium payment of Rs. 4000 per month with a policy term of 15 years. The total assumed benefit @ 8% would be Rs 11.43 Lakhs and at an assumed rate of return of 4% p.a., the total benefits would be Rs 8.33 Lakhs. Values are illustrative and actual benefit may depend on number of factors, including future investment performance. Advt No. W/II/1187/2015-16.This calculation is generated on the basis of the information provided and is for assistance only. And is not intended to be and must not alone be taken as the basis for an investment decisionThe calculations mentioned above take into consideration an assumed rate of inflation of 8%. #The current costs of education mentioned above are approximate values. The end value displayed is on the basis of the information provided and is for assistance only. It is not intended to be and must not alone be taken as the basis for an investment decision. *A 30 years old healthy male can start the plan with a premium payment of Rs. 4000 per month with a policy term of 15 years. The total assumed benefit @ 8% would be Rs 11.43 Lakhs and at an assumed rate of return of 4% p.a., the total benefits would be Rs 8.33 Lakhs. Values are illustrative and actual benefit may depend on number of factors, including future investment performance. Advt No. W/II/1187/2015-16.