Understand the compounding effect of Money

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Understand the compounding effect of Money
Valuing and understanding the power of compounding effect is most important when it comes to making financial decision. Just to give you an idea of this power let us take you through an example.

Suppose you had invested Rs1,000 today in a 5% savings account. In one year, that account would be worth Rs1,050 i.e. [Rs1,000 + (Rs1,000 x 5%)], This gives you return of Rs50 which if your gain, also referred to as yields.

However, in year two, that same initial investment would be worth Rs1,102.50 [Rs1,000 + (Rs1,000 x 5%) + (Rs1,050 x 5%)], yielding a Rs52.50 gain.

At the end of third year, the same Rs1,000 would be worth Rs1,157.63 [Rs1,000 + (Rs1,000 x 5%) + (Rs1,050 x 5%)+ (Rs1,102.50 x 5%)], yielding a Rs55.13 gain.

So at the end of ten years, the initial Rs1,000 investment would be worth Rs1,629 and by year 25 it would be worth Rs3,386.

Now the key learning from the above example, as you can also see is that investing Rs1,000 today is more valuable compared to investing Rs1,000 few years down the line.

Therefor, to create wealth, using the time value of money to your advantage through proper compounding effect to your advantage is important.

This second example shows how the compounding effect can work against you:

Suppose you borrowed Rs 20,000 to purchase a bike and your loan was at a 10% interest rate (for 5 years). So your monthly payments would be at Rs 424.94. Because Rs 20,000 loan continues to compound over the life of the loan.

So you end up paying Rs 25,496.45 over the five-year period. This means that you have in essence paid Rs 5,496.45 because you spent the money before you had it.

In fact, in your initial payments, the interest alone will account for almost 40% of your monthly payments. In this case, the bank or lender that gave you the loan uses the time value of money to their advantage.

Utilizing this unique power of compounding to your own benefit for investing i.e. mutual funds, stocks, deposits etc is what makes people better at financial decisions.

OneIndia Money

Story first published: Tuesday, June 14, 2011, 14:23 [IST]
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