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What is Power of Compounding?

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  | Published: 13 January 2021 | Last Updated On: 02 February 2021

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Most of us start investing our capital with the objective of growing it over time so that we can achieve our goals at an accelerated pace. Several financial experts and experienced investors often refer to compounding as a magical tool that helps you to grow your capital faster and more efficiently. In fact, compounding actually is an investor’s best friend. 

You might be asking yourself, but how? Are there specific conditions where compounding works? How do I use compounding to build a corpus? The best part about this entire concept is that it is very easy to understand and apply to real-time scenarios. In order to make sure you make the best out of your investment plans in your journey, we’ve come up with a new blog where we will breakdown the concept of compounding for you. 

First thing’s first, let us take a close look at what actually is compounding? And how to use it to build a stronger and effective investment portfolio. 

Understanding Compounding

Compound interest commonly known as compounding is a mathematical concept that is widely used by financial institutions and banks to determine the increase in the value of a given asset over time. The increase in the value of an asset is mainly due to the interest earned by the investor on the principal amount along with accumulated interest. 

Simple interest which is another concept similar to compounding allows investors to calculate the increase in value only on the principal amount. Simply put, the major difference between both concepts is that in the case of compound interest the principal amount is variable and tends to change annual due to the addition of interest. However, contrary to this in the case of simple interest, the principal amount remains constant during the entire course of the investment. 

Slowly and gradually the small increase in principal, allows investors to get better returns and this is why compounding is considered to be an investor’s best tool. In order to get a better understanding of compounding let us consider an exemplary situation. 

Hatim and Saad invest AED 50,000 at an interest rate of 10% for a period of 10 years. Hatim opts for simple interest and Saad chooses compound interest to determine the returns on their investment plans. By the time their plans mature, Hatim ends up with AED 100,000 but Saad ends up with a whopping AED 130000. This difference is based on the fact that the interest in Hatim’s case was calculated on the principal amount of AED 50,000 that remained constant for 10 years. On the other hand, interest in the case of Saad’s investment was calculated on a variable principal that included the annual increment on the principal. 

Benefits of Compounding

When it comes to the benefits of compound interest the list is long. With every year the interest you earn on your principal amount will be added to determine the interest for next year. This allows investors to yield returns faster and make money from money. Here’s a rundown on the main benefits of compounding. 

  • The first and foremost benefit of compounding is that it provides better and faster returns in comparison to other modes such as simple interest. 
  • Allows the investor to make the best use of investment plans to yield optimum returns. 
  • Motivates the investor to keep investing in order to get the best returns over time. 
  • Works in case of almost all types of investment plans. 
  • Works for small as well as large investment amounts.  

Power of Compounding 

Wealth creation and management is an art, and with the power of compounding, one can yield the best returns via discipline and regular monitoring. The beauty of compound interest is that it is valid for the smallest amount you could think of, which makes it the right tool for wealth creation. Most of the time, people willing to invest stop because their capital is small. However, with the right knowledge of investment and the correct set of tools you can make the best of even very small amounts.  

Compound Interest Calculator

Investors looking forward to calculating the exact return they can reap can simply make use of a compound interest calculator to determine the output. Compound interest calculator is an algorithm based virtual tool that calculates the interest over an amount. All you need is the principal amount, rate of interest, and the investment tenor. Simply enter the values in the fields of the compound interest calculator and with a click you can get the returns on your principal amount.  

Tips to Make the Best use of Compounding

Start early

Don’t wait for reaching a threshold before you start investing. Instead, start investing with small amounts with the right approach to obtain the best returns. The most important point to be kept in consideration is that the longer the investment window better the returns. 

Choose the Right Investment Plan/Tool

The second most crucial factor that determines the return on investment is the plan. The investment market is extremely diverse and filled with options, the catch here is that one needs to choose plans that suit your budget and provides expected returns. 

Consistency

The investment journey is highly reliant on the consistency of investment. With a uniform frequency of investment, you not only increase the potential returns but also start creating a bigger platform to intensify your future returns.  

In a Nutshell

Your dreams and goals are not far away from you with the right knowledge and the power of compounding. Start investing if you haven’t yet, if you are investing focus on the nuances of the process and educate yourself and fellow investors about compounding to make the best out of your investment plans.