Compounding Explained: How It Works and Why It Matters

Compounding is a very powerful tool when it comes to creating wealth as it allows your investments to grow exponentially over time, leading to significantly higher returns as compared to simple interest.

Compound interest accelerates the growth of your money as it does not just calculate your initial principal but also the accumulated interest over time, which eventually may lead to a snowball effect, where both the original investment as well as the earnings from it continue to grow together.

What Is Compounding?

Compounding means earning interest on previously earned interest.

The funds you initially invest generate earnings from the original principal amount and accumulated interest earnings from past compounding phases.

This is different from simple interest as the interest is not solely calculated on the principal sum.

Strategic investments in such instruments can help you grow your wealth faster.

For instance, if you invest a sum of Rs 10,000 per month starting from the age of 25 to 60 years, which is a span of 35 years, at a CAGR of 12% you will earn a corpus of Rs 6.4 crore.

Additionally, if you invest the same amount for just 15 years, from 45 to 60 years, you will earn a corpus of Rs 50.9 lakh.

Advantages of Compounding

Here are some advantages of compounding:

1. Growing Savings Faster: You can boost your savings faster with the help of compound interest as your interest earning gets reinvested into the original principal, adding to your returns.

2. Long Term Growth: Staying invested for the long-term make your returns most visible as each compounding phase adds to your corpus.

3. Reduces Risk: Compounding is also a great tool for hedging against inflationary pressures and is a good way of protecting your savings from rising levels of inflation.

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