When talking about finance and wealth, simple interest is the easy form of calculation of interest on investments. It works on the basic principle of percentage addition to the principal amount for the number of years applicable without any change in the base amount. Although it is a simple way to calculate interest, most financial instruments available in the market work on the principle of compound interest.
What is compound interest and how does it work?
Simply, compound interest is the interest earned on interest itself. Compounding means the computing of interest on the initial amount invested and also on the accumulated interest of the previous periods. Here, with every change in the period, the base principal changes because it is an addition of the original based principal along with the interest of the previous period. Although the rate of interest remains the same between the transition of periods, the amount of interest on with every success increases severely due to the addition of interest in the previous year. It is safe to say that compounding differs from linear growth where only the principal is on the interest in each period.
For example, take the base amount of rupees 1000 at 8% compound interest per annum. The interest after the first year would be rupees 80 and the base principal for interest calculation for the next year would be rupees 1080 instead of rupees 1000. So, the interest will be 8% of rupees 1080.
How to invest to earn compounded returns?
The secret to earning compounded returns is to begin early. A long-term investment strategy that has the consistent discipline and a clear understanding of how compounding works. It is a chain reaction by generating returns on the returns as long as the money remains invested in the financial instrument. Instruments including a systematic investment plan also known as SIP take advantage of the compounding effect where you can invest small sums of money at a predefined interval to see it grow exponentially over a specific period. Time is a very important factor when investing for compounded returns.
Mathematically speaking, the shorter the time interval of compounding, the greater the impact on the returns. Higher the rate, the more the rate of returns gained. Suggest investing in equities that have a long investment horizon because they offer a better potential rate of return over a long period. This is the miracle of compounding and only small points need to be kept in mind to make full use of them to accumulate wealth and see one’s financial portfolio snowball into a big chunk of funds. Several types of calculations for averages in finance are available but when calculating average returns of an investment or savings account it is best to use a geometric average which is also known as the time-weighted average return or the compound annual growth rate in some cases. It is seen that healthy growth over a long period has always been working on a strong and sound foundation of compounding returns.