When it comes to growing your money and fighting against things like prices going up and your money losing its value, there’s a super important concept you should know about the power of compound interest. In this blog post, we’re going to dive into the world of compounding and show you how it can help you become wealthier over time. You’ll discover some awesome tips on how to make the most out of this powerful financial tool. So, let’s jump right in and learn how to make your money work for you!
The Context
Compounding is the practice of earning interest on both the invested principal and any accrued interest over and over again.
This means that the interest earned in a given period is added to the principal, and the next period’s interest is calculated on the new, higher balance, and so on. Over time, the effect of compounding can significantly increase the value of an investment.
Compounding, which enables you to receive returns on your investments without actively contributing fresh funds, is the most important element of building functional financial portfolios. This can be extremely helpful in maximizing wealth, especially for individuals who are unable to contribute regularly.
How To Use Compounding?
Starting to save and invest as early as possible is the greatest method to take advantage of compounding for the best results. For example, if you start saving ₹5,000 per month into a retirement bucket with an annual interest rate of 8% at the age of 25, you would have over ₹1 Crore by the time you reach 60.
However, if they wait until age 35 to start saving the same amount, they would only have about ₹44 lakhs at age 60. That’s a huge difference of about ₹56 lakhs stemming from delaying your investments by just 10 years! This is because the money has been invested for a longer period (35 years) in the first scenario, allowing for more compound interest to accumulate.
Another preferred way of using compounding for the best results is investing in a diversified portfolio of stocks, bonds, gold, and other assets. This helps to mitigate the risk of losing money due to the performance of any one particular investment.
Additionally, it is a good idea to routinely rebalance the portfolio to return it to its original allocation. By doing so, you’ll be able to profit from any large price changes in one or more assets and increase your portfolio’s overall returns.
The Benefits Of Compounding
≡ Increased Earnings: Reinvesting earnings for compounding is easily possible and can eventually result in higher returns over time.
For example, if you invest ₹10,000 at an 8% fixed annual interest rate; at the end of the first year, you would earn ₹810 in interest, bringing the total value of the investment to ₹10,800. In the second year, you would earn 8% interest on the ₹10,800, rather than just the original ₹10,000. This means that you would earn ₹864 in interest, bringing the total value of the investment to ₹11,664
As you can see, even if the interest rate stays the same, compounding causes the interest earned in the second year to exceed the interest earned in the first year. Compounding hence can considerably enhance the value of an investment over time, which is why it is frequently referred to as the “eighth wonder of the world.”
≡ Time Value of Money: Compounding takes advantage of the time value of money, which means that money invested now will be worth more in the future due to the potential for additional earnings.
According to the idea of the Time Value of Money (TVM), money today is worth more than the same amount in the future. This is so that money can accumulate interest or other returns over time, such as dividends in the case of stocks.
≡ Tax Advantages: In some cases, compounding can provide tax advantages by allowing investments to grow tax-free or at a lower tax rate.
One example of a tax advantage in compounding is the use of tax-deferred or tax-free accounts such as EPFs, Mutual funds, and PPFs. For taxable investments, profits only become taxable when they are transferred to your bank account, so holding your money in such instruments helps delay taxes and allows compounding to do its magic.
Due to the lack of taxes on the interest, dividends, or capital gains produced on the investments within the account, the money in these instruments can compound over time at a quicker pace than it would in a taxable vehicle like Fixed Deposits (FDs).
In contrast, when funds are withdrawn from these instruments upon retirement, they are subject to income tax.
≡ Risk Reduction: Compounding can help to reduce risk by spreading investments over a longer period, which can smooth out the impact of market fluctuations.
≡ Building Wealth: Reinvesting earnings can result in investments growing exponentially over time, which is a great way to accumulate wealth.
Conclusion
Compounding yields excellent results for investors who stay committed to slowly growing their investment over time. It is a powerful way to build wealth and the key to success is to start saving and investing early, diversifying assets, and regularly re-balance the portfolio.
This guide aims to provide a deeper understanding of the concept to aid in securing financial success. Please seek the advice of a certified investment advisor if in doubt.
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