Everyone has heard of the power of compounding when it comes to wealth accumulation and investing. Compounding allows you to make money while you sleep, and the more money you save or invest, the more money you will make thanks to compounding.
But what is compounding and how does it work?
What is Compounding?
There are two ways in which interest is calculated. The first is simple interest and the other is compound interest. In simple interest, the principal amount on which you earn interest remains the same throughout the duration of your investment. In contrast, compound interest allows you to add earlier interest to your principal amount.
For example, let’s suppose you invest Rs. 1000 with a compound interest of 10% per year.
In the first year, your principal amount will be Rs. 1000 and you will earn Rs. 100 in interest.
However, in the second year, your principal amount will become Rs. 1100 and you will earn Rs. 110 interest.
Your principal amount and interest will keep increasing over time as long as hold the investment.
Over long periods of time, compound interest will help you exponentially increase the value of your investment.
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Factors that Play an Important Role in Compounding
The two factors that you need to consider to understand how much money you can make are the rate of compound interest and the duration of the investment. The higher the rate of interest and the longer the duration for which you invest, the more money you can make.
For example, let’s suppose that you invest Rs. 1000 with 10% annual interest for ten years. check out the table below to see how compounding works over long periods of time.
As you can see, in just ten years, the amount of money grew two and a half times (assuming a rate of interest of 10%) due to compounding.
How can you take advantage of compounding in mutual funds?
In order to realize the benefit of compounding, you will need to reinvest the amount of interest that you have earned.
For example, if you invest in a mutual fund, then you should take the “growth” option rather than the “dividend” option.
The growth option means that the money you earned from your mutual fund investment is reinvested into the mutual fund. This will make your investment grow much faster. In contrast, the dividend option will release the money that you have earned back to you. This money will stop earning for you, and the total value of your investment will remain the same.
Summary
Remember that it takes time for the power of compounding to work its magic. You should be patient and hold your investments for as long as possible to see the best results. Through compound interest, you can increase the value of your investment much faster than through simple interest. According to the above example, your investment would be worth just Rs. 2000 if we use simple interest.
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