The Power of Compounding and the Rule of 72

Compounding! Once you start your journey in Investment, the word that you would love is Compounding. So, let’s first understand what the meaning of the word is. Compounding in simple words means increase in the value of your investment due to the interest earned on your principal as well as on your accumulated interest. So basically, by compounding, you are earning interest not only on your main principal amount that you have invested but also on the interest that you have earned over time. It’s a powerful method to grow your wealth. 

There are two types of Interest that one can opt for; Simple interest and Compound Interest. 

In Simple Interest, you get interest paid on your principal amount only. This is suitable for people who need regular income from their investment, basically senior citizens. While in the case of Compound Interest, the interest is paid on the principal as well as the interest that you have earned earlier. Over the period of time, the interest snowballs into a substantial amount. This is suitable if you plan to stay invested for a longer period of time and not in need of interest income for your basic needs. Mostly young investors go for it who have time in hand and don’t mind locking in their principal income and interest income. 

Let’s compare this with an example. 

Mina and Tina both plan to invest INR 50,000/- each with an annual interest of 10% for a period of 10 years. While Mina opts for simple interest, Tina chooses compound interest. At the end of the tenure, Mina will get a total of INR 1,00,000/- of which interest would be INR 50,000/- while Tina would earn a total of INR 1,30,000/- out of which interest would amount to INR 80,000/-. So clearly, Tina is gaining more here due to the power of compounding as she is earning interest on her interest. 

Now let’s see in detail how you benefit in compound interest by taking another example. 

You plan to invest INR 3000/- every month, i.e. 36,000/- each year, for the next 30years at a fixed interest rate of 7%. By the end of 30 years, your total investment made would be INR 10,80,000/- while the compound interest earned on this would be a whooping INR 24,68,031/- 

This table itself speaks volumes about the gains that one makes when compounding their investment. But keep in mind, the one to gain more is the one who starts investing early. You don’t need a hefty amount to get you started with investments. An amount as small as INR 500/- can also help you secure your future. 

Now lets look at the Rule of 72. 

What is Rule of 72 you ask? Its noting but a simple formula which will help you gauge the number of years you will need to double your investment at a given rate of interest. We have Microsoft excel who can run the calculations for us, but this formula comes handy for mental calculation to get the approximate value. 

The formula goes as such

Years to Double the investment = 72/ Interest rate

So, if you are getting an interest rate of 4%, your investment will double in 72/4 = 18 years. 

This method can be used to calculate anything that grows at a compounded rate, be it GDP, population, loans or charges.  

The rule of 72 provides a roughly accurate number or a timeline keeping in mind that it’s a simplified version of a complex logarithmic calculation. Also, this same calculation can be applied to your debts. For example, it can be used to know how long it will take for credit card companies to earn double of your money. So, if your interest rate on credit card is 13%, it will take them 5.5years to double that amount from you. The higher the interest rate, the more you have to pay to the lenders. This rule can also be used to catch the words hidden under the fancy jargons used by banks or take a debt that might cost you dearly. 

In my next blog I will compare Long term investment with Short term investments. Till then, stay tuned and have a happy weekend. 

This blog is a part of Blogchatter’s #blogchatterA2Z challenge.