The Power of Compounding

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

Years	Interest Rate	Amount	Amount in words (Rounded)
0	10%	5,00,000	5 Lakhs
5	10%	8,05,255	8 Lakhs
10	10%	12,96,871	13 Lakhs
20	10%	33,63,749	34 Lakhs
30	10%	87,24,701	87 Lakhs
40	10%	2,26,29,627	2 Crores 26 Lakhs

 

5 Lakhs at 16% Compounding

The BSE Sensex has managed to give a 16% CAGR over the last 38 years

Years	Interest Rate	Amount	Amount in words (Rounded)
0	16	5,00,000	5 Lakhs
5	16	10,50,170	10 Lakhs
10	16	22,05,717	22 Lakhs
20	16	97,30,379	97 Lakhs
30	16	4,29,24,938	4 Crores 29 Lakhs
40	16	18,93,60,579	19 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

Years	Interest Rate	Amount	Amount in words (Rounded)
0	20	5,00,000	5 Lakhs
5	20	12,44,160	12 Lakhs
10	20	30,95,868	31 Lakhs
20	20	1,91,68,799	1 Crore 91 Lakhs
30	20	11,86,88,156	12 Crores
40	20	73,48,85,783	73 Crores

 

5 Lakhs at 25% Compounding

Years	Interest Rate	Amount	Amount in words (Rounded)
0	25	5,00,000	5 Lakhs
5	25	15,25,878	15 Lakhs
10	25	46,56,612	47 Lakhs
20	25	4,33,68,086	4 Crores 68 Lakhs
30	25	40,38,96,783	40 Crores
40	25	376,15,81,922	376 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

Years	Interest Rate	Tax Rate	Amount	Amount in words (Rounded)
0	8	20%	5,00,000	5 Lakhs
5	8	20%	6,80,378	7 Lakhs
10	8	20%	925,830	9 Lakhs
20	8	20%	17,14,322	17 Lakhs
30	8	20%	31,74,343	32 Lakhs
40	8	20%	58,77,806	58 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%

Years	Interest Rate	Tax Rate	Amount	Amount in words (Rounded)
0	8	30	5,00,000	5 Lakhs
5	8	30	6,54,735	7 Lakhs
10	8	30	8,57,355	9 Lakhs
20	8	30	14,70,118	15 Lakhs
30	8	30	25,20,829	25 Lakhs
40	8	30	43,22,497	43 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