- Date : 22/02/2017
- Read: 5 mins
Learn all about compounding - the beginners' edition
By Sunil Dhawan
The early bird catches the worm, as the saying goes. Similarly, beginnings made early in life are supposed to bring in success. And similar is the case with money matters. As good habits are to be learnt early in life, making savings a habit as a youngster could go a long way in shaping one's financial future.
Someone who starts saving at an early age gets the advantage of compounding, whereby interest earned participates in future earnings. And, the longer the savings period, the more time one gives to the interest income to grow.
How compounding works
Let's see how compounding works. Calculation of interest can be done in two ways- simple interest and compound interest. In simple interest, interest is earned only on the initial capital. Say, on a deposit of Rs 10,000, if 7 percent is simple interest, then at the end of 3 years, total interest paid will be Rs 2,100.
In case of compounding interest (which can be daily, monthly, half-yearly or annually), interest is initially calculated on the initial capital and thereafter on the accumulated interest of the previous period too. Continuing with our earlier illustration, if Rs 10,000 is invested at 7% p.a. compounded annually, at the end of three years, the interest earned would be Rs 2,250. Had the compounding been quarterly or half-yearly, the interest component would be Rs 2,314 and Rs 2,293, respectively.
It, thus, shows that simple interest grows in a linear fashion while compound interest grows exponentially.
Related: Why investing early is important
Power of compounding
Take, for example, A who started investing Rs 2,000 every month from the age of 25. Then there is B, who started investing Rs 5000 per month when he reached the age of 35. When both A and B turn 45, on a realistic 12 per cent return, A's kitty will turn to a sizeable Rs 20 lakh, while B's will be nearly half at Rs 9.30 lakh, despite B investing more than A. With age on the side of most youngsters, you can avoid the same predicament as that of B.
Let's see the power of compounding in the above illustration:
Total investment by both A and B is Rs 4.8 lakh. The difference is in the period of investing. While A invests for 240 months, B invests for 120 months, but a higher amount.
For A, interest income earned comes to Rs 15.20 lakh in a corpus of Rs 20 lakh (nearly 76 percent) while for B it is Rs 4.5 lakh in a corpus of Rs 20 lakh (nearly 48 percent).
Make compounding work harder
To make compounding work in your favour, there are two important things - frequency of compounding and the period of investment. The third, however, are the returns generated which may not always be in your control. Compounding works best when the interval of compounding is shortest. The above illustration shows that the shorter the compounding interval, the more is the interest amount on maturity. This is because the earnings in the form of interest are re-invested more frequently and made to participate in future growth. And, to reap more benefits out of compounding, let the process continue over a longer period.
Related: Gift yourself the gift of compounding
Youngsters may not have long-term goals on their radar, but that should not make them discard the savings process. They need to realise that along with their lifestyle expense, the savings can also go hand-in-hand. The 'investing can wait' attitude needs to be overcome. Procrastination can be the biggest enemy of compounding. For all those who do not have the inclination towards financial matters, the savings process itself may pose perplexing questions such as how much to save, where to save etc. but, that should not deter them and instead a beginning needs to be made.
To start saving, one should follow a simple formula, i.e. save before you spend. Usually, it's the other was round as youngsters spend first and then think of saving what remains. This pattern may even be followed by anyone and not just the youngsters. This approach not only inculcates a savings habit, but also brings about a balance in the spending pattern by reducing impulsive and non-discretionary expenses.
How much to save
It is immaterial how much one starts to save. Even a small amount of savings can create a big enough corpus if invested for a longer time horizon. What is important is to keep investing on a regular basis and not disrupt the process by withdrawing from it. For youngsters even a beginning made by saving 10 percent of one's income can be a good start.
An early start gives a head start to the investing process. One also needs to realise that in order to create wealth over time by effectively using the power of compounding, upgrading from savings to investing is the mantra. Spend time in identifying your goals based on tenure. Link long-term goals to your long-term investments primarily through equities. For medium-term goals benefit from a mix of debt and equity asset classes. Start investing towards each specific goal and let compounding work to your advantage.
Source: Economic Times