Understanding the Power of Compound Interest

Wonder what would the right age for you to start investing? Wonder how compound interest can play a role in making this decision? Hopefully this post will help you get some answers. 

“My wealth has come from a combination of living in America, some lucky genes, and compound interest.”

– Warren Buffett

What is compound interest?

Compounding is the process where the value of an investment increases because the earnings on an investment, both capital gains and interest, earn interest as time passes.[1] We can see an exponential growth because in case of compounding, the total growth of the investment till that period along with the principal, earn money in the next period. This differs from linear growth where only the principal earns interest in each period.

Example:

Principal Amount= Rs. 1000

Annual rate of interest= 6%

Time Period= 5 years

Year Interest Amount at the end of the year
2012 (1000)*(6/100) = 60 1000+60 = 1060
2013 (1060)*(6/100) = 63.6 1060+63.6 = 1123.6
2014 (1123.6)*(6/100) = 67.416 1123.6+67.416 = 1191.016
2015 (1191.016)*(6/100) = 71.460 1191.016+71.46 = 1262.476
2016 (1262.476)*(6/100) = 75.748 1262.476+75.748 = 1338.224

 

In the example, the amount at the end of 2012 is Rs. 1

Please note that it is not a straight line, it is a curve.

060 after adding 6% interest to the initial principal of Rs.1000. At the end of 2013, the interest will be calculated on, and added to the new amount of Rs. 1060. Similarly for the next 3 years, implyi
ng an exponential growth in the amount invested. At a 6% annual interest rate, the Rs. 1000 invested in the beginning of 2012 has increased to Rs. 1338 approx by 2016, due to compounding.

Compound Interestad1f9b68a27431f0f1c6c7f786cbbcd1

  • P = principal, your initial investment
  • r = interest rate
  • n = number of time periods (years/months/days, etc.)

The Power of Compound Interest

The graph below by JP Morgan shows the difference between the returns 3 different investors get, due to compounding, who begin investing at different times. The 3 investors:

Susan

– Invests from the age of 25 to 35 ie 10 years

– Invests $5,000 annually, $50,000 in total

Bill

– Invests from the age of 35 to 65 ie 30 years

– Invests $5,000 annually, $1,50,000 in total

Chris

– Invests from the age of 25 to 65 ie 40 years

– Invests $5,000 annually, $2,00,000 in total

chart-jp-morgan-retirement-1

Intuitively, it makes sense for us to say that Chris will end up with much more money, compared to Susan and Bill, by the time he turns 65. However, we shouldn’t forget that the amount he has saved is enormous in comparison to how much Susan and Bill saved. Chris contributed steadily for his entire career. If you didn’t notice, his savings are the combination of Susan and Bill’s savings.

Susan, who saved for just 10 years, has more wealth than Bill, who saved for 30 years. This is due to the power of compound interest. All of the investment returns Susan got in her first 10 years of saving have been expanding exponentially.

The longer you wait to start saving for retirement, the more you miss out on the benefits of the power of compounding.

“I made my first investment at age eleven. I was wasting my life until then.”

– Warren Buffet

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