One of the basic funda of getting rich is understanding the concept of compound interest.
If you have wondered why the rich seem to be getting richer, its because compounding is working in their favour.
Almost everyone has placed a deposit with a bank. It is easy to understand the concept of fixed deposit and interest.
Lets illustrate,we place a deposit of Rs. 1 lac with a bank suppose for three years @ the rate of 8%.
It is simple enough idea.
We give the bank Rs. 1 lac, the bank gives us Rs 8000 per year as interest to us. After 3 years gives us back our 1 lac.
We have two choices when we place a deposit.
Either we tell the bank to give us the interest of Rs.8000 every year which we can spend or we tell the bank that we don’t need the interest and pay us back the principal with interest after three years.
If the bank were to pay us simple interest whether we take back the interest every year or all together after 3 years, this is what we would get.
Simple Interest = (Principal * Rate of interest * No. of years)
Calculated = 100,000 * 8% * 3 .
= 1,24,000/-
But if the banks were paying us a compound intetest and we opt to take back interest after 3 years this is calculation of how much the bank will pay us.
For year 1 the interest due to us Rs. 8000. (100,000 * 8%)
For year 2, @ the interest will be calculated on the principal + interest for the first year ie on108000.
Accordingly the interest due to us for year 2 will be Rs.8640.
For Year 3,@ the interest tdue to us will be principal + interest for 2 years , ie100000 + Rs.16,640 = 1,16,640 @8% = 9330
So at the end of Year 3 , you will get your principal Rs. 1lac + interest Rs.8000+Rs8640+Rs9330=25,970
ie you will get Rs 1,25,970/-
Against that if you were earning simple interest you would get 1,24,000/-.As calculated above.
The basic explanation of compounding is that if the interest is not paid out to you but retained by the borrower you can earn interest on interest which was earned for the earlier periods.
Compounding ends up multiplying your money quickly the longer your period of investment larger the gain.
For eg if your fixed deposit is for 3 years Rs. 1 lac @8%,
@the end of 3 years if you had compounded you would get – additional Rs. 2000/-
As compared to what you would earn against simple interest.
5 years – additional Rs.7000/-
7 years- additional Rs.15,000/-
10 years – additional Rs.35000/-
as compared to Simple interest.
For the academics the formula for compound interest is as below.
The math and the gain becomes more interesting when the compounding is done in shorter periods.
So if Bank A accepts a fixed deposit with yearly compounding @8% and Bank B accepts fixed deposit with quarterly compounding @8% then Bank B is giving you a better deal.
If you understand compounding then you have understood the mystery of the financial universe.
As Einstein has said “ He who understands earns it , he who doesn’t Pays it.”
Sejal Goel
This article is absolutely simple to understand. Wonderfully drafted. Loved reading it.