Compounding, the eighth wonder of the world.

Compounding,the eighth wonder of the world.

Eight wonder of the world.

Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it earns it… he who doesn’t… pays it.” 

So by this let's see what is compounding and how we can use it for our own advantage. Utilizing the power of compound interest is how most of those "Millionaire next door" types actually became the Millionaires next door. They aren't smarter than you, hard-working than you, or better at picking winning lottery number than you. They just know how compounding works and make it work for them.

So, what is compound interest?

Compound interest is interest on the principal amount plus whatever interest has already accumulated. Or simply compound interest is interest on interest.

The principal amount is the amount invested, and interest(rate) is a percentage profit for the money you have invested.

And here is the formula:

Amount= 

principal(1+ Rate/No. Of times interest is compounded per year) Time.

But, compounding takes time and as early you invest the more you will see the power of compound interest. Let us see one example.

Here is a story of a father who had two daughters and a son, they were of the same age. From their 20th birthday, the father would pay ₹50,000 each till they were 65 years old. They were free to use this money in whichever way they wanted.

The father suggested to them that could invest the money in a good fund, which would pay them a return of 12% compounded year on year but after investing they couldn't take out the money till they turn 65.

Despite telling their attitude towards money and savings we're very different. Here is how they spent their money.

• The son starts investing from his 20th Birthday. He invested his first nine 50k that he received in the fund, after that he spends all the money that he received yearly.

• The first daughter initially spends the money. However, she got a little serious from her 28th birthday. She decided to invest the money like her brother. So, she invested from her 28th birthday till her 36th birthday. And the money received after her 36th birthday was spent.

• The second daughter spends her money till her 27th birthday. But after that, she got serious and invested all her money till she turned 65 years old.                         

So, what do you think who would have taken advantage of the power of compounding?

• The 2nd daughter has saved 19L, which grows to a massive 3.04Crs by the time she turns 65 years old.
• The 1st daughter has saved 4.5L, which grows to 1.98Crs by the time she turns 65 years old.
• The son saves 4.5L, but it grows to a whopping 4.89Crs by the time he turns 65 years old.

Got confused?

So, this is the power of compounding. This is why you should know the time value of money because it plays a key role in personal finance.

And this is why you should start investing early to get the taste of compound interest.

~By Suddha.