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Compounding

Power of Compounding

The great scientist Albert Einstein once called Compound Interest the Eighth Wonder of the World. This view has also been corroborated by the renowned investor Warren Buffet.

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

Compounding is a financial phenomenon that has the power to generate enormous wealth over the long term.

You may wonder how. In this blog, we will explain why compounding is the most powerful tool for wealth creation.

How does compounding work?

It is an act of earning interest over interest, i.e., you earn interest on the amount and the interest accrued on it in the previous period.

Compound interest differs from simple interest in which one earns interest on the original investment.

Let’s understand this with an example.

You decide to invest Rs 1,00,000 for five years at an interest rate of 10%. The table below illustrates how the simple interest would work.

Year
Amount at the beginning of the year
Simple Interest Earned
Amount at the end of the period
1 1,00,000 10,000 1,10,000
2 1,10,000 10,000 1,20,000
3 1,20,000 10,000 1,30,000
4 1,30,000 10,000 1,40,000
5 1,40,000 10,000 1,50,000

Now, let’s find out what compound interest will do for your investment.

Year
Amount at the beginning of the year
Compound Interest Earned
Amount at the end of the period
1 1,00,000 10,000 1,10,000
2 1,10,000 11,000 1,21,000
3 1,21,000 12,100 1,33,100
4 1,33,100 13,310 1,46,410
5 1,46,410 14,641 1,61,051
Formula for Compound Interest

You can also see how much you will accumulate at the end of the investment period with the help of a compound interest formula.

A= P (1+ r/n) ^(nt)

where A= Amount at the end of the period

P= Principal
R= Rate of interest
N= Number of times interest is compounded every year
T= Number of years for which the money is invested

You can also use a compound interest calculator to calculate how much wealth you will accumulate over the years.

Harnessing the Power of Compounding

It’s wise to start early and stay invested for a long time to make the best out of the principle of compounding. It’s also prudent to step up your investments periodically to make the base larger, enabling greater benefits of compounding. Reinvestment of interest or dividends further augments the investment corpus, setting the stage for substantial gains in the future.

Get access to Top fund ideas, curated SIP packs and more with SC Invest.

FAQs on Compounding Interest

  • Beginning a small SIP or lump‑sum investment a decade sooner can dramatically boost your final corpus, thanks to the power of compounding. To help you understand how, here are two scenarios to consider.

    Scenario 1: You begin investing ₹3,000 every month starting at age of 25 and stop after 10 years. You then let it grow until the age of 65, assuming roughly 10% annual returns. At this stage, you’d end up with approximately ₹1.2 crore.

    Scenario 2: You start investing ₹3,000 every month at the age of 35 for 10 years. Again, you let it grow till the age of 65, assuming a 10% rate of return. In this scenario however, you’d end up with just a little over ₹ 45 lakh, a full ₹60+ lakhs less than someone who started at 25.

    Even modest early investments may snowball over time.

    Delaying your start by even a few years can require much larger monthly contributions to hit the same goal.

  • Inflation gradually erodes the purchasing power of your investment. Even if your savings grow in nominal value, their ability to buy goods and services may shrink over time unless your returns exceed inflation.

    • For example, with a 10% nominal return but 6% inflation, your real growth is only around 4%, meaning your compounding effect is significantly diluted.

  • The Rule of 72 provides a quick way to estimate how long it takes for an investment to double under compound interest. Simply divide 72 by the expected annual return rate. For example, at 12 % per year, your investment doubles in roughly 6 years (72 ÷ 12).

    This method is especially handy for mental math and planning. However, it is an approximation. The precise calculation requires the formula:
    A=P×[(1+r/n )]^(n t)

    That method yields exact results and can account for different compounding frequencies.

  • Compounding grows gradually at first, like in the "8‑4‑3" rule scenario, where gains accelerate after compound interest starts building on earlier interest as well as principal. Early years yield modest gains, but as the corpus builds, growth becomes exponential.

  • While the power of compounding may provide for accelerated wealth generation, there are several mistakes an investor can make which could potentially diminish real returns.

    Some of these include timing the market rather than spending time in the market, making emotional investment decisions, and failing to factor in the effects of inflation on the returns of their investments, as well as that of taxes.

  • A disciplined annual step-up regime (Say, 10% per year) on one’s investments helps raise the base amount on which returns compound year-on-year. This helps your final corpus at the time of retirement grow exponentially. Our online SIP calculator lets you factor in and adjust your desired yearly step-ups in your investments, to calculate the returns you may expect on the same over a specific period.

  • No, the compounding power depends on returns and whether those returns are reinvested. Equity dividends, interest income, and capital gains compound only when you reinvest them. Funds with higher long‑term returns (e.g. equity) may compound more effectively than low‑yield debt funds.

  • Yes, starting late or investing for fewer years reduces compounding benefits, but you can still maximize outcomes by:

    • Investing larger amounts
    • Choosing higher‑growth instruments (with suitable risk)
    • Minimizing withdrawals

    Staying invested without interruption