The compound interest formula can teach us the basics of long term investing. We heard about simple interest and compound interest way back in our school days (Class 8th). But in those days, we never realized that these formulas had so much learning for us
I feel, had our teachers exemplified us more about compounding returns in those days itself, today our money quotient would’ve been better. Anyway, we can’t complain because more or less we all are in the same boat.
But the thing is, several years have passed since our school days, as today do we understand the utility and difference between these two formulas? No. Why care about it? Because they can help us make some money.
Don’t worry. I’m telling you a story. It may be a boring story but will certainly give you a peep inside the concept. It will help beginners to visualize the controlling parameters in long term investments.
Simple Interest: A Story
There was a person named Raj who received Rs.1,00,000 as a bonus from his employee. He wanted to spend the money on a later date. Hence he decided to let it idle & generate some passive income from it.
He opened an FD in his bank and gave a standing instruction that, at the end of the year, the interest portion shall be credited in his savings account. Raj kept the FD live for 2 years.
At the end of the first year, he got an interest income of Rs.7,500 (@7.5% on Rs.1.0 lakhs) credited to his savings account. The balance principal amount of Rs.1.0 lakhs was continued as FD. Similarly, at the end of the second year, he again got an interest income of Rs.7,500.
Please note that what Raj was earning on his deposit each year was simple interest.
What was the sum-total of this investment exercise? Principal plus first interest, plus the second interest [Rs.(1,00,000+7500+7500) = Rs.1,15,000]. The passive income so generated was Rs.15,000 in two years.
The outcome of this FD could have been better than above. How? By making the deposit earn ‘compound-interest’ instead of ‘simple-interest‘. What to do differently? To know this, let’s read another story.
Simple Interest Calculator
Compound Interest: A Story
Raj received Rs.1,00,000 as a bonus from his employee. He wanted to use the money after 2 years from now. Hence he decided to keep the money in a bank FD for the next 2 years.
He opened an FD in his bank. He also gave a standing instruction to credit the principal amount and the accrued interest into his savings post maturity (after 2 years).
In our simple interest story, even after the first year, the principal amount remained at Rs.1,00,000. Why? Because Raj withdrew the interest portion (Rs.7,500). But here, Raj allowed the interest to stay-put along with the principal amount. Hence, for year two, the principal amount became Rs.107,500. This amount then earned the interest @7.5 per annum at the end of the second year.
Just because Raj decided to let his money stay invested, he could take advantage of the power of compounding. In this story, Raj made Rs.1,15,563 at the end of the second year. This is more than what he made in story #1.
So what can we learn from these two stories? We will learn about a formula that highlights the parameters that we need to control in long term investing. These controlling parameters can make us large amounts of money in times to come.
Compound Interest Calculator (Lump-sum Investing)
Compound Interest Formula – Learn about long term investing
For me, this one formula can give clarity about long term investment like none other. It is easy to understand things using a formula. Right? The compound interest formula can teach us about the best investment strategy.
To be a successful long term investor, we must know how to control three parameters. What are these parameters? Let’s see each of them one by one: But before that, let’s talk about the goal of investing money.
Why we invest money? We invest money to build wealth (final amount shown in the above formula). This is our financial goal. It could be like a child’s higher education, retirement corpus, down-payment for home purchase, etc. To reach the goal successfully, we must control three parameters immaculately. Let’s know more about them:
The Three Parameters
- #1 Invested Amount: The larger will be the initial investment, the bigger will be the final amount. This is the reason why, if you have funds, investing it in lump-sum and staying invested for the long-term can yield the best benefits. Read more about the thought process for lump-sum investing.
- #2 Rate of Return: High return on investment can make the goal-achieving easier. But with high-return comes the possibility of high-risk of loss. So to ensure that in-the-rush for high returns, the unnecessary risk is not taken, what to do? The rule is to invest in one’s comfort zone. Yes, one can also study investment options to widen one’s comfort zone. Read about investment basics.
- #3 Time Horizon: This is perhaps the simplest to understand and execute among the other two parameters. Just keeping one’s money locked in an investment for the long-term (like 20+ years) can build wealth. But we do not have endless times in our hands. What is the solution? Sadly there is no quick-fix to this rule. The best we can do is to start as early as possible.
Benefits of Compound Interest
Allow me to give you another example of compound interest to see its benefits. In this example, we will again compare simple interest with compound interest.
Suppose you have Rs.1.0 Lakhs available for investing. You decided to invest this money in a hybrid mutual fund. This fund can yield 10% p.a. return on average for the next 20 years.
Had you not invested in a hybrid fund, and invested in an FD (say @10% p.a) paying-out annual income, you would be relying on simple interest. Using this route, your investment corpus would have become only Rs.3.0 lakhs after 20 years (check using this calculator).
A hybrid mutual fund, held for 20 years, yielding a 10% p.a. return would have increased your corpus from Rs.1.0 lakhs to Rs.6.72 lakhs in 20 years (check using this calculator).
To understand the effect of compounding more visually, we have provided a graph that draws a comparison between your initial investment, the final amount after simple-interest, and the final amount after compounding. Check the orange area to appreciate the benefit of compounding.
Effect of compound interest while investing systematically (SIP)
I’ve written a separate article about SIP returns. I’ll suggest you kindly read that article as well. You may find it both useful and controversial. Why controversial? Because it may not align with your understanding of SIP plans offered by Mutual Funds.
Anyways, to talk about compound interest applied for monthly investments, I thought to provide an online calculator instead of a formula. Why? Because the mathematical formula for SIP investments is a complicated one. It might raise more doubts than give clarity.
Conclusion
The objective of this article was to highlight the importance of the compound interest formula for long term investors. This formula highlights three controlling parameters that an investor should remember while investing money. Altering any one parameter can significantly effect the final outcome.
I’ve also added online calculators related to simple interest, compound interest (lump-sum investing), and compound interest (SIP investing). You can use these calculators in tandem to know the effect they have on your final amount.
Have a happy investing.
