I was only vaguely familiar with the concept of compound interest till a few years ago. It’s something we learned in our Class 7th/8th Maths class, to be conveniently forgotten once exams were over, so that we could free up memory storage for the next cycle of exam torture.
But once I started earning and had some money saved up, I started searching for investment options. And compound interest was everywhere! I was astonished to learn that something as ubiquitous as a Fixed Deposit (FD) was also based on the concept of compound interest. When I started down that rabbit hole, I learned one of the fundamentals of long-term investing: Compounding is magic!
Let me help you understand it with an example. You’ve saved up Rs. 10,000 to invest, and you have 2 investment options that pay you the same Annual Rate of Interest, 10%, over an investment period of 5 years. But one scheme offers Simple Interest and the other offers you interest compounded once annually.
For schemes that earn Simple Interest, the principal amount on which interest is calculated will stay the same for each investment year (Rs. 10,000 in our example). The interest earned is credited to you periodically.
When it comes to compound interest, interest earnings are reinvested into the scheme, so that your principal amount also grows with time. In effect, your interest will start to earn interest, which will itself earn interest down the line, and so on.
In our Simple Interest scenario, you receive in your bank account Rs. 1,000 as interest at the end of every year. At the end of 5 years, you will receive your principal of Rs. 10,000, plus interest earnings of Rs. 5,000.
In the case of interest compounded once annually, there is no difference in earnings by the end of Year 1.
But now, the magic begins! Instead of receiving Rs. 1,000 interest in your bank account, that amount is also invested and added to your principal amount. Your principal amount for Year 2 is now Rs. 11,000! So by the end of Year 2, you earn an interest of Rs. 1,100 on this principal.
For Year 3, the principal becomes:
Rs. 10,000 + Rs. 1,000 + Rs. 1,100 = Rs. 12,100!
By the end of Year 5, your Rs. 10,000 investment will have grown to Rs. 16,105.10, compared to a simple interest value of Rs 15,000. If we compare only the interest earnings from the 2 schemes, then the Compound Interest scheme earns 22.1% more interest (Rs. 6,105 vs. Rs. 5,000) than the Simple Interest scheme.
Compound Interest is a concept central to all investment instruments, especially those with a lock-in period (such as Fixed Deposits). Such schemes typically ask investors to commit their funds for a certain time period, during which the interest accrued is compounded annually, semi-annually, quarterly, monthly, or sometimes even daily.
Over longer investment periods of 10-20 years, compounding makes an even bigger difference.
In our above example, if we extend our time frame from 5 years to 20 years while keeping the Annual Rate of Interest 10%, the Simple Interest scheme would grow our investment from Rs. 10,000 to Rs. 30,000.
For interest compounded annually, the closing amount would be Rs. 67,275, which is more than double compared to the simple interest scheme! The Compound Interest earned in Year 20 would be Rs. 6,116, over 6 times the Rs. 1,000 earned in the case of Simple Interest.
This, folks, is the magic of compounding!