Investing

Herald: The Eighth Wonder

03 Aug 2020  |   05:10am IST

The Eighth Wonder

Neetant D Sinai Shirodkar

From an early age I was intrigued by the thought of doing something today that my future self will thank me for later in my life. And as much as this thought disturbed me for a brief while the solution was simple and elementary, that is to save. As I complete 5 good years of my writing with this column let me take this opportunity to thank my readers by reiterating the mantra of money which speaks only one language, ‘If you save me today, I will save you tomorrow’. So how is it that you can become rich merely by saving today? The answer is with the help of compound interest. 

What is Compound Interest?

Albert Einstein once famously quoted that Compound interest is the eighth wonder of the world. One who understands it, earns it…. One who doesn’t …pays it. On a solemn note, when people think of interest, they often think of debt. But interest can work in your favour when you are earning it on money you have saved and invested. Compound interest can be defined as interest calculated on the initial principal and also on the accumulated interest of previous periods. Think of it as the cycle of earning ‘interest on interest’ which can cause wealth to rapidly snowball. Compound interest will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount. Not only are you getting interest on your initial investment, but you are getting interest on top of interest! It’s because of this that your wealth can grow exponentially through compound interest and why the idea of compounding returns is like putting your money to work for you.

Why it’s important to save now?

The magic ingredient that makes compound interest work best is time. The simple fact is that when you start saving outweighs how much you save. An investment left untouched for a period of decades can add up to a large sum, even if you never invest another pie. Let’s see how compound interest works with the help of an example. Garima, Suraj and Vrittiare good friends who earn the exact same 7% annual interestcompounded monthly on their investment say in a Public Provident Fund account. The only difference is when and how often they save. Garima invests Rs 5,000 every month beginning at age 20. At the age of 30, she stops. She has invested for 10 years, a total of Rs 6 lakh. Suraj invests the same amount of Rs 5,000 every month, but begins where Garima left off ie he begins investing at the age of 30 and continues until he retires at the age of 60. Suraj has invested for 30 years and his total investment adds up to Rs 18 lakh. Vritti is our most diligent saver. She invests the same Rs 5,000 every month beginning at age 20 and continues investing until her retirement till the age of 60. She has invested for 40 years and her investment totals up to Rs 24 lakh. At the time of retirement ie at age 60 their respective savings will grow as shown in the table below:

From the table above we can see that Suraj has invested 3 times as much as Garima, yet Garima’s account has a higher maturity value. She saved for just 10 years while Suraj saved for 30 years. This is the effect of compound interest: the investment return that Garima earned in her 10 early years of saving is snowballing. The effect is so drastic that Suraj can’t catch up, even if he saves for an additional 20 years.

The best scenario here is Vritti, who begins saving early and never stops. Note how the amount she has saved is massively higher than either Garima or Suraj. Is it so phenomenal that Vritti’s savings have grown so large? Not necessarily. What is most remarkable is how simple her path to riches was. Slow and steady annual investments and most importantly beginning at an early age. Compound interest favours those that start early, which is why it pays to start now. It’s never too late or too early to start.

If you are early in your career, it can feel like there are a lot of things competing for your money between student loans, saving for a house, retirement and more. However, saving now can give you a huge edge on your finances so you can retire stress-free. If you want to easily accumulate wealth and take advantage of the magic of compound interest, it’s important to start early and be consistent.If one desires time can be your best friend, the bad news is it flies, the good news is you are the pilot.

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