The Power of Compounding

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I wish I had understood the power of compounding better when I was in my early 20’s. These are 15 years of compounding I’ve have lost and cannot get back. I’m sure most people know what compounding is but very few people understand it’s significance over 20-30+ years of investing. Albert Einstein considered compounding to be the 8th wonder of the world.

What is compound interest?

Compounding of interest is nothing but getting interest on the initial amount invested and also on the accumulated interest of the previous periods. Simply put, it is earning interest on interest.
Compounding is all about Patience. The longer you wait the more money you will make.

Compounding in Action

In order to understand the power of compounding it might help to see some of the figures in action. Let’s say you make an initial investment of Rs 5,00,000 (5 lakhs). The below tables shows you the final returns after 5,10,20,30 and 40 years at various different interests rates.

5 Lakhs at 10% Compounding

YearsInterest RateAmountAmount in words (Rounded)
010%5,00,0005 Lakhs
510%8,05,2558 Lakhs
1010%12,96,87113 Lakhs
2010%33,63,74934 Lakhs
3010%87,24,701 87 Lakhs
4010%2,26,29,6272 Crores 26 Lakhs

 

5 Lakhs at 16% Compounding

The BSE Sensex has managed to give a 16% CAGR over the last 38 years
YearsInterest RateAmountAmount in words (Rounded)
0165,00,0005 Lakhs
51610,50,17010 Lakhs
101622,05,71722 Lakhs
2016 97,30,37997 Lakhs
30164,29,24,9384 Crores 29 Lakhs
401618,93,60,57919 Crores

 

5 Lakhs at 20% Compounding

Warren Buffett according to his letter to shareholders managed around 20% return on average compounded annually. This 20% compounded over 60 years, it brought him from a few million dollars to top 3 richest person on the planet
YearsInterest RateAmountAmount in words (Rounded)
0205,00,0005 Lakhs
52012,44,16012 Lakhs
102030,95,86831 Lakhs
20201,91,68,7991 Crore 91 Lakhs
302011,86,88,15612 Crores
402073,48,85,78373 Crores

 

5 Lakhs at 25% Compounding

YearsInterest RateAmountAmount in words (Rounded)
0255,00,0005 Lakhs
52515,25,87815 Lakhs
102546,56,61247 Lakhs
20254,33,68,0864 Crores 68 Lakhs
302540,38,96,78340 Crores
4025376,15,81,922376 Crores

 

5 Lakhs deposited in a bank FD at 8% compounding (20% tax)

Now lets say you deposit you 5 lakhs in a Bank FD which promises you a 8% interest rate
YearsInterest RateTax RateAmountAmount in words (Rounded)
0820%5,00,0005 Lakhs
5820%6,80,3787 Lakhs
10820%925,830 9 Lakhs
20820%17,14,32217 Lakhs
30820%31,74,34332 Lakhs
40820%58,77,80658 Lakhs

 

5 Lakhs deposited in a bank FD at 8% compounding (30% tax)

Now lets say you deposit you 5 lakhs in a Bank FD which promises you a 8% interest rate. The Income tax rate assumed here is 30%
YearsInterest RateTax RateAmountAmount in words (Rounded)
08305,00,0005 Lakhs
58306,54,735 7 Lakhs
108308,57,3559 Lakhs
2083014,70,11815 Lakhs
3083025,20,82925 Lakhs
4083043,22,49743 Lakhs

 

Unfortunately a lot of us waste our time and money with bank FDs. After 40 years your 5 lakhs COULD become 18 crores if invested in an equity index vs only 58 lakhs (assuming you fall in the 20% tax bracket) if invested in bank FDs. Even if you have to pay 10% long term capital gains tax (LTCG) on your equity you still stand to make 16+ crores. You can read more about Should you invest in Fixed Deposits (FDs) or Mutual Funds?

Useful tools

Compound Interest Calculator

3 thoughts on “The Power of Compounding

  1. Thank you Mr. Amit. It’s like a platinum tip for the buddiing investors. This proves to be the best opportunity for the middle class working individuals to give their kids their desired future.

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