Albert Einstein once famously said “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
Mathematically, compound interest is defined as, “the increase in the value of an investment due to the interest earned on the principal, with the accumulated interest”. Simply put, it’s a strategy to make your money work for you. By reinvesting your income in your assets you can grow your wealth exponentially. It is regarded as a powerful tool to grow your wealth, and can be used to plan your long term goals.
We can understand this better with an example. Suppose you invest 1 lakh in a 5-year fixed deposit with a bank, at an interest of 8.5% per annum (compounded quarterly). Now, you have two options-
Opt for a fixed deposit where the interest is paid out every 6 months
Opt for a cumulative option, where the interest is reinvested.
If you chose to reinvest, you’d receive an additional interest which is 5.5% higher!
Every time you reinvest your income from dividends on investments, your capital (principal) goes up. The next time you earn interest, it is on this increased capital and is thus higher than it was earlier. So if you think about it, you actually lose out by not investing. Another major factor which influences this compounding is the frequency of compounding. This refers to the frequency at which interest is calculated (monthly, quarterly, annually etc.) and reinvested. As the frequency of compounding increases, the interest rate correspondingly increases.
You may be wondering how this applies to you, possibly even thinking, “I’m a teenager. How am I supposed to use ‘the power of compounding’? ”. As children, we’ve all been taught to save up our money. All the cash we get on birthdays, Diwali, or when relatives come over is secretly stowed away safely in a box or drawer. Now imagine, instead of saving it and letting it collect dust in a drawer, you invest the money. The earlier you invest your money, the greater the rewards! As CNBC’s “Mad Money” host, Jim Cramer said, “The magic of compounding works best the younger you are, because that means you have more time for your money to grow,” Financial literacy is important and more than relevant at our age as it teaches us to make better decisions. It’s up to you to take that first step!
If you’d like to read more about compounding, be sure to check out Aryan’s article in Issue 31 of The Teen Tribune weeklee newspaper!