Whenever you have to do anything related to finances or banking, you come across the term ‘interest’. Interest is nothing but a payment over and above the principal amount that a bank pays for a savings account, a fixed deposit account, or what it charges when a borrower takes a loan. Back in our school days, we learned the two types of interest, simple interest, and compound interest. It is this interest that really makes the financial world go round. When you invest in fixed deposits you receive interest returns that over the long term can help you accumulate wealth. So what is simple and compound interest and how does it help you create wealth? Let’s find out.
All of your investing works on compound interest, but before we find out what that is, we must understand simple interest. Simple interest is nothing but an interest amount you earn every year for a principal sum. For example, if you invest Rs. 10,000 for a period of 5 years with an interest rate 5% per year, you will receive 5% of 10,000, which is Rs. 500 every year. It is a linear form of interest and it will remain the same even if you invest for a hundred years.
Compound interest, however, is a whole different ball game. In compound interest, the interest that you earned in your first year is added back to the principal amount and this combined amount is now your new principal amount. The interest in your second year will apply to this new combined amount. Again for the third year, the latest interest is added again to your principal amount and this goes on for as long as you’re invested. This compounding effect will eventually grow exponentially and over a long period will grow into a sizable corpus.
If we again take the same example of 5% interest on Rs. 10,000 for a period of five years, we find that the first year will give the same interest return as simple interest, which is Rs. 500. However, in the second year, the earned interest of Rs. 500 is added back to the principal amount and the new interest earned will be on Rs. 10,500, instead of the original principal of Rs.10,000. So the second year compounded interest will be Rs. 525. For the third year, again the new interest of Rs. 525 will be added to the new principal amount of Rs. 10,500, This will give you Rs. 11,025 and again the 5% interest is applicable on this combined amount. Thus, every year, through the power of compounding your gains will keep increasing. The gains may seem insignificant in the short run but over a long period, these gains will become bigger and bigger if you remain invested.
Mutual funds also benefit similarly from the power of compounding. Your returns are added back to your investment and the whole sum is again re-invested. When this happens over a long period of time, your investment will grow exponentially.
To answer the question in the title of this blog, yes, the effect of compounding is much better if the time horizon is longer. That is the very reason why financial advisors ask investors to start investing as early as possible, because even a delay of a few years will lead to a huge difference in the returns that you earn.