There is a popular saying in finance: There are only two types of people in this world. Those that earn interest and those that pay interest. Which category do you fall under? Depending on which side of the coin you are on, compound interest can either elevate your life and goals to the next level or be incredibly detrimental to your financial health and adversely impact your quality of life.
What is compound interest?
Simple interest is the interest calculated on the initial principal amount for a loan or investment. This means that the actual amount of interest earned every period would be the same as long as the interest rate remains the same. In contrast, compound interest is the interest calculated on both the initial principal and the accumulated interest from previous periods. This means that the interest for the following period will always be higher than the previous period, as long as the interest rate remains the same.
The power of compounding
Compound interest is a powerful tool that can increase any initial capital at staggering rates as long as the time period is significant enough. Imagine two friends, Priya and Raj. Priya wanted to start her investment journey early and set aside Rs 50,000 for 10 years, between the ages of 18 to 28, to create a retirement fund. Raj thought 18 is too early to start investing. He wanted to get settled in a stable job before making any such commitments. Hence, Raj started at 28 and continued to invest Rs 50,000 towards his retirement fund all the way till he retired at age 62. Assuming a 12% annual return in both cases, let’s see how both of them fared.
- Priya:
- Total amount invested = Rs 5,00,000
- Size of retirement fund = Rs 4,63,28,327
- Raj:
- Total amount invested = Rs 17,50,000
- Total returns received at retirement = Rs 2,15,83,175
These results are staggering. By waiting for 10 years to start investing, Raj’s retirement funds were less than half of Priya’s in spite of investing more than three times what she did. This demonstrates the significant impact of compounding perfectly.
Friend or foe?
As evident in the example above, compound interest can be a great friend when it comes to growing wealth. However, there are situations when it can be an equally dangerous foe. Some of these are:
- Inflation and rising costs of living: If you ask your parents or grandparents, they will testify that it always seems like the rate of increase in expenses is always going up. Their perception would not be far from the truth. This is because inflation has a compounding effect on the cost of living per annum, worsening the skyrocketing costs. This is why you need to make sure that you invest to beat inflation.
- Crumbling under the debt burden: If you overburden yourself with too many loans and fall into a situation where you miss your loan repayments, you are setting yourself up for disaster. Compounding works against you in this case, further worsening the problem. As such, it is critical to keep paying down your principal and interest regularly and try not to miss out on your EMI payments.
The goal is to make sure you always keep the power of compounding on your side and take adequate measures to mitigate or avoid the above situations. Figuratively speaking, you want to be the person that earns interest and not the person that pays interest (unless it is good debt and helps you achieve your goals).
Bottom Line
Compound interest was called the “8th wonder of the world” and “man’s greatest invention” by Albert Einstein and for good reason. Focus on ensuring that you leverage the compounding effect to work for you rather than against you. The simplest way to do that is to invest in a diversified portfolio of mutual funds where the interest and dividends are reinvested to capitalise on this effect of compounding. It can become the most important determinant of how much wealth you can accumulate through your working life.