Monday, September 12, 2011

Invest early – Magic of Compounding

Mr. Amay bought a house for Rs. 20 lakhs 10 years ago, and today it costs Rs. 50 lakhs. Isn’t that a whopping sum of money? Appreciation by Rs. 30 lakhs!

Well, not if you understand the principle of compounding. If Mr. Amay would have invested the same Rs. 20 lakhs for a period of 10 years, at an interest rate of 9.60% compounded annually, he would have made Rs. 50 lakhs today. That’s how phenomenal the power of compounding is.

What is compounding?

It refers to re-investment of the interest earned, at the same rate at which the principal was invested year after year. Assume an investment of Rs. 1000 in a fixed deposit for 3 years, at an interest rate of 10% p.a., compounded annually. Your interest earnings would be as under
Particulars Amount at the beginning of the year Interest Earned 10% p.a. Balance at the year end
Year 1 1,000 1,000*10% = 100 1,100
Year 2 1,100 1,100*10% = 110 1,210
Year 3 1,210 1,210*10% = 121 1,331

Notice, at the end of year 2, your interest is calculated on Rs. 1,100 and not Rs. 1,000. That’s where the brilliance of compounding comes into play. Had the simple interest principle been followed, you would have earned interest on Rs. 1000 and hence interest earned in year 2 would have been lower by Rs. 10 and in year 3 it would be lower by Rs. 21.

Investment Options in the market with the feature of compounding 

For tax saving purposes and for general investment purpose (retirement planning), many of us invest in fixed interest instruments. Interest on the same is compounded at varied intervals.

Instrument Compounding Frequency
National Saving Certificate Half yearly
Public Provident Fund Annually
RBI Relief bonds Half yearly
Post office Time deposit Quarterly
Kisan Vikas Patra Half yearly
Government Securities Half yearly
Bank FD’s Minimum: Quarterly
Corporate FD’s Minimum: Quarterly. It differs from entity to entity
Corporate Bonds (Non convertible debentures) Minimum: Quarterly. It differs from entity to entity

Compounding is a very powerful tool and in order to obtain maximum benefits out of it, we need to make it work best for us.

When does the magic of compounding work best?

If you want the magic of compounding to work best for you i.e. to provide astounding returns, make sure you take into consideration the following factors
  • Time: Start early and give your money longer amount of time to work for you. Time is the crucial factor and not the quantum of money. The more time you give your money to compound, the larger the sum you will amass in the future. A case in example-
At the age of 25, Tina invests Rs. 10,000 @7% p.a. for 10 years
At the age of 35, Anitha invests Rs. 10,000 %7% p.a. up to the age of 58
Both of them retire when they are 58 years. Let’s see the difference in the wealth amassed.
Although Tina has invested only Rs. 100,000, she is able to amass Rs. 7.5 lakhs at the age of 58 years because she started investing 10 years earlier than Anitha. On the other hand, in spite of investing a total of Rs. 240,000, Anitha is able to amass only Rs. 6.22 lakhs (Rs. 1.27 lakhs lower). This clearly indicates that, the time for which the investment is done is the key, rather than the sum. Even a small sum of money can make you richer if you are able to invest early.
  • Frequency: The more frequent the compounding is done (i.e. daily, monthly, quarterly, semi-annually and annually), the better it is. Assume an amount of Rs. 20,000 invested in a fixed deposit at an interest of 10% p.a compounded at varied frequencies and for different tenures

Under the quarterly compounding option, the amount of money amassed is the highest, followed by semi-annual compounding, followed by annual compounding.
In year 1, quarterly compounding earns you Rs. 26 more than semi-annual and Rs. 76 more than annual compounding
In year 5, quarterly compounding earns you Rs. 194 more than semi-annual and Rs. 562 more than annual compounding
In year 10, quarterly compounding earns you Rs. 635 more than semi-annual and Rs. 1,826 more than annual compounding
Albert Einstein rightly termed it the “most powerful force on earth.” Compound interest helps you amass wealth by making your money work hard for you. Make sure you start investing now as it’s never too early to invest. The earlier you start investing, the richer compound interest will make you. Also next time, you look at any fixed interest instrument; make sure your interest is compounded at the maximum available frequency. Make your money work for you.
Source : rupeetalk

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