Compounding is a very simple and yet a powerful concept but few understand it well. We can’t blame the rest as the concept of compounding is quite boring and its power is visible only in the very long run. And in this fast-paced world, very few cares about things which are not exciting. It also does not help that the effects of compounding are visible not in the short run but over a long period of time. But as important it is, let’s try to decode compounding in a simple manner and what it can do to an investors’ wealth over a period of time.

In layman terms, compounding income means that you begin to earn income on the income you receive, and this multiplies your income at an accelerating rate. In other words, if you have Rs 1 lakhs and it earns 10% interest, you will have Rs 1.1 lakhs at the end of the year. Then, in the following year, you will not only earn interest on the original amount of Rs 1 lakhs but also on the Rs10 thousand which was earned as interest during the last year. As a result you will have Rs 1.21 lakhs at the end of the following year.

Let us try to understand the power of compounding through illustrations and tables.

  1. Imagine there are four people who are all saving Rs 1 lakh every year and invests to get returns. Lets assume they are getting returns of 6%, 10%, 14% and 18% respectively. The table below suggests the cumulative amount each of such person will amass at the end of various periods.
Time/Return 6% 10% 14% 18%
10 Years 1,79,085 2,59,374 3,70,722 5,23,384
15 Years 2,39,656 4,17,725 7,13,794 11,97,375
20 Years 3,20,714 6,72,750 13,74,349 27,39,303
25 Years 4,29,187 10,83,471 26,46,192 62,66,863
30 Years 5,74,349 17,44,940 50,95,016 1,43,37,064

Looking at this, we see that the amount varies between the periods and the interest rate by a large amount. We can say that two factors determine the compound interest returns-

  • The interest rate that is earned on the investment, or the profit that is earned.
  • Time left to grow. The more time you give your money to earn ,the more it compounds

2. Suppose there are two persons and one of them start saving for retirement at the age of 25 and the other one starts saving at the age of 40. Both of them save the same amount by the age of 60 and the amount gets compounded. We see that there is a huge difference in the corpus of the two by the time they retire.

  Person 1 Person 2
Age to start saving 25 40
Period 35 20
Investment (monthly) 5000 8750
Total Investment 2100000 2100000
Return 8% 8%
Compounded Wealth ₹ 1,14,69,412 ₹ 51,53,929

So learnings for us

  • We should start investing in our early years to enjoy the power of compounding
  • Even a small extra return matters a lot in the long term.