Compounding is said to be the most important and also the simplest of all financial concepts that you could learn. It could give you an answer to your question of "how do I make money from an investment?" or "how do I make money using money?".
You might recall learning compound interest in school; we mean the exact same thing when we say 'compounding.'
What is interest?
Interest is what you earn as a reward for lending your money. For example, you pay interest at the rate fixed by the bank when you take a loan. Similarly, the bank pays you interest for your deposit in the bank account, that they use to make investments or lend it to other customers.
In general, there are two types of calculating interest; Simple and Compound. Let us understand the difference to learn about compounding better.
What is the difference between simple and compound?
In simple interest, the interest on your deposit is only calculated on the base principal amount that you must have invested. In case of compounding the interest that you earn in the first period is added to the principal and taken as a base for further evaluation.
We shall take Rs. 10,000 as the principal amount and 10% as the rate of interest per annum to keep it simple. In this example, let us also assume that the amount was never withdrawn in the given five years and interest was computed annually.
|Years||Simple (in Rupees)||Balance at the end of the year (in Rupees)||Compound (in Rupees)||Balance at the end of the year (in Rupees)|
As you can see in the table above, the rate of interest is same for the first year in both the methods. The change occurs from the second year when the base for interest calculation remains 10,000 for simple interest but changes to 11,000 for compounding.
The above example was an ideal situation which required basic calculations. But what if you want to calculate how much you will earn on your investment based on the fact that interest will be computed more often than once a year. You could use the formula
A = P (1 + r/n)^(nt)
A: the future amount you will receive
P: the amount you will be investing
r: rate of return
n: number of times the interest will be compounded in a year
t: number of years you plan to keep your money invested
Compounding in Investment
If you were to invest Rs. 10,000 with an annual return of 10%, using the above formula, in 10 years you will get:
So in ten years, you will have gained Rs. 15937 (rounded off) in addition to the Rs. 10,000. Whereas, in case of simple interest you would have made just Rs. 10,000 more (Rs. 1000 x 10 years).
Compounding is based on the idea that you will reinvest whatever amount you earn as interest to multiply it further. Now imagine if you add more to this 10,000 as and when you have the money. Your investment will yield more and the goal to get Rs. 25,000 in ten years could be close to a few months.
In what kind of investments yield compound interest?
- Bank accounts:
A bank account deposit is a classic example of compounding. Savings, fixed and recurring accounts earn interest on the same methodology. Banks compound interest every quarter, while some other institutions like the government of Kerala owned KTDFC, compound interest every month.
There are a lot of government bonds that have varying interest rates and the period of compounding also differs. If you choose a cumulative bond, the interest gets accumulated for compounding, and you will get the amount with the principal on maturity (or sooner if you withdraw).
An interesting thing about bonds is the inverse relationship between bond prices and bond yields. As a bond price increases, the bond yield falls.
- Equity Stocks:
Although stocks are non-interest bearing investments, they do yield dividend. If you reinvest the received dividend for shares of stocks, then those shares will grow along with your existing investment. Unlike bank accounts, this form of investment can grow at a much faster pace if you invest wisely. This will also help you in widening your investment portfolio.
Now you know that non-interest bearing investments too that can help you multiply your money.