Unleash the power of compounding

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If you are wondering how do I make my money work for me, this is the right place for you. You have worked hard at your job to earn your living. Now after all the expenses you have money that you have in the bank. The goal of this article is to make you aware of the power of compounding and how you can make your money work hard for you.

The power of compounding works by growing your wealth exponentially. It adds the profit earned back to the principal amount and then reinvests the entire sum to accelerate the profit earning process. Suppose, you invest $1000 in a bank which offers 10% interest per annum. Your investment becomes $1100 after the first year, then $1210 after 2nd year and so on.

Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on principal plus interest. It is the result of reinvesting interest, or adding it to the loaned capital rather than paying it out, or requiring payment from the borrower, so that interest in the next period is then earned on the principal sum plus previously accumulated interest. Compound interest is standard in finance and economics.

Compound interest is contrasted with simple interest, where previously accumulated interest is not added to the principal amount of the current period, so there is no compounding. The simple annual interest rate is the interest amount per period, multiplied by the number of periods per year. The simple annual interest rate is also known as the nominal interest rate

Here are the four main components of compound interest:

Principal

The principal is the amount that is originally deposited in a compounding environment (for example, a high-interest savings account at a bank). It is the starting amount upon which the first interest payment is calculated.

Interest Rate

The interest rate refers to the rate that is paid on the account value. The interest payment will be equal to the interest rate times the account value (which is the sum of the original principal and any previously paid interest).

Compounding Frequency

The compounding frequency determines how many times a year the interest is paid. It will influence the interest rate itself as high-frequency compounding will typically only be available with lower rates. Typically, compounding occurs on a monthly, quarterly, or annual basis.

Time

Time horizon refers to the amount of time over which the compound interest mechanism can operate. The longer the time horizon, the more interest payments that can be made and the larger the ending account value will be.

Consider the following example for a detailed understanding of the power of compounding.

The formula for Compound Interest:

P(1 + r/100)n - P Where P is the principal amount, n is the number of years, and r is the rate of interest. Suppose you invested $ 1,000 at the age of 20, and the stock is giving you 12% interest (capital appreciation) every year. You intend to invest for 10 years and realize your total amount after the completion of the period.

Scenario 1: You withdraw the interest earned every year.

In this case, after 10 years, you would have earned $ 1,200 (120x10) as interest. With the principal amount being $1,000 your total investment value will be $ 2,200 (1,000+1,200).

Scenario 2: You re-invest your interest every year and add it back to the principal amount.

In this case, according to the formula, you will earn $2,105 as interest after 10 years. With the principal amount being $1,000 your total investment value will be $3,105 (1,000+2,105). Thus, with the power of compounding, you will earn $905 more than if you withdraw your interest every year.

Benefits of Power of Compounding

Here are the benefits of the power of compounding:

1. It helps in multiplying the principal amount by a huge margin over time.
2. It allows investors to earn returns and then increase the return potential in the next cycle.
3. It requires less time with the power of compounding to multiply the investments when compared to simple interest.
4. The power of compounding can be executed for any financial instrument for increasing the return potential.
5. It doesn’t require extensive financial knowledge to implement successfully.

The power of compounding is one of the most vital factors in increasing wealth over time. It is the holy grail of financial management and, if done with discipline, can allow you to garner immense wealth over time.