Power of Compounding

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The great scientist Albert Einstein once called Compound Interest the Eighth Wonder of the World. This view has also been corroborated by the renowned investor Warren Buffet.

“Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t……pays it.”- Albert Einstein.

Compounding is a financial phenomenon that has the power to generate enormous wealth over the long term.

You may wonder how. In this blog, we will explain why compounding is the most powerful tool for wealth creation.

How does compounding work?

It is an act of earning interest over interest, i.e., you earn interest on the amount and the interest accrued on it in the previous period.

Compound interest differs from simple interest in which one earns interest on the original investment.

Let’s understand this with an example.

You decide to invest Rs 1,00,000 for five years at an interest rate of 10%. The table below illustrates how the simple interest would work.

Year	Amount at the beginning of the year	Simple Interest Earned	Amount at the end of the period

1	1,00,000	10,000	1,10,000
2	1,10,000	10,000	1,20,000
3	1,20,000	10,000	1,30,000
4	1,30,000	10,000	1,40,000
5	1,40,000	10,000	1,50,000

Now, let’s find out what compound interest will do for your investment.

Year	Amount at the beginning of the year	Compound Interest Earned	Amount at the end of the period

1	1,00,000	10,000	1,10,000
2	1,10,000	11,000	1,21,000
3	1,21,000	12,100	1,33,100
4	1,33,100	13,310	1,46,410
5	1,46,410	14,641	1,61,051

Formula for Compound Interest

You can also see how much you will accumulate at the end of the investment period with the help of a compound interest formula.

A= P (1+ r/n) ^{^(nt)}

where A= Amount at the end of the period

P= Principal
R= Rate of interest
N= Number of times interest is compounded every year
T= Number of years for which the money is invested

You can also use a compound interest calculator to calculate how much wealth you will accumulate over the years.

Harnessing the Power of Compounding

It’s wise to start early and stay invested for a long time to make the best out of the principle of compounding. It’s also prudent to step up your investments periodically to make the base larger, enabling greater benefits of compounding. Reinvestment of interest or dividends further augments the investment corpus, setting the stage for substantial gains in the future.

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Power of Compounding