power of compounding interest

Power of Compounding: How It Helps to Grow your Money Faster


Last Updated on 03/06/2020 by NM Staff

Renowned American motivational speaker and author, Michael Sylver says: “Either make your money work for you or you’ll always have to work for your money.”

Robert Kiyosaki, author of bestseller ‘Rich Dad, Poor Dad’ says: “Schools teach you how to work for money, but they don’t teach how to make money work for you.”

Both these quotes hold true for the majority of the Indians. Because Indians lay special emphasis on job security since they don’t know much about making money work to their advantage. Secondly, the Indian education system is pathetically bereft of topics to educate students over the importance of investments.

Above all, majority of Indians look for safe investment avenues due to their inherent lack of appetite for high-risk-high-return options such as stocks, commodities and currencies.

Fortunately, such Indians that are wary of exposing their hard-earned money to high-risk investments, the power of compounding provides some relief.

What’s the power of compounding? It’s not some esoteric term that financial wizards use. Hence, I’ll simplify what power of compounding means.

Understanding Power of Compounding

Let’s assume you’ve invested Rs.1,000 in some plan or scheme. And this investment offers you Rs.100 per annum as returns or interest. You’ll have two options. The first option is to withdraw the Rs.10 and spend the amount while keeping your investment intact to earn more money.

The second option is leaving the Rs.100 with the invested amount of Rs.1,000. Thus you have Rs.1,100. And in the second year, you’ll get returns or interest on Rs.1,100 which would definitely be slightly higher. And as the years pass, your principal amount of Rs.1,000, as well as the interest, goes on accumulating to become a very large sum.

That’s how the power of compounding works.

However, the power of compounding also has a flip side. This is especially true if you have a credit card. If you spend Rs.1,000 on a credit card, it’s possible to pay only the minimum amount as monthly instalment.

Let’s consider you paid only Rs.100 by availing the ‘revolving credit’ or something similar, attractive yet confusing facility. The issuer or bank will charge you a stiff interest over the balance Rs.900 you failed to pay. So the next month, you might get a credit card bill for say Rs.950.

And if you pay only 10 percent- or Rs.95- interest will be calculated on the balance Rs.855. While you’ve paid Rs.195 for purchase of Rs.1,000, the actual amount reduced from your bill is only Rs.145.

Hence, the power of compounding can work against you as well.

However, it’s quite easy to get the power of compounding work in your favor. How? By selecting the right savings and investment products.

Therefore, let’s glance at some such investments where you can tap the power of compounding to your advantage.

Mutual Funds

Mutual Funds are the hottest investment option in India. Mainly due to massive public awareness and advertising campaigns conducted by the Association of Mutual Funds of India and other entities. These ads target the Indian middle-income group or what is known as ‘middle class’ that wishes to invest smaller amounts of money for the highest possible returns.

Anyone that’s buying Mutual Funds or subscribing to their Systematic Investment Plans (SIP) has four options: Regular Dividend, Regular Growth, Direct Dividend and Direct Growth.

Mutual Fund companies also pay out dividends if you opt for Regular Dividend or Direct Dividend options. Means, you’ll get the dividend amount by cheque or demand draft or by direct bank transfer.

The other option ‘Regular Growth’ and ‘Direct-Growth’ doesn’t pay cash dividends. Instead, the Asset Management Company will credit a few additional units of the Mutual Fund, worth the dividend value to your portfolio.

These units will earn more dividend that translates as more units. Hence, over a period of years, the number of units you hold turn out to be greater than the ones you actually paid for.

Here, you stand to gain in two different ways: the value of each unit would have risen considerably over a period of years. Hence, your lump sum or SIP Mutual Fund is now worth much more than your invested amount. And with more units in your portfolio, you’re getting better returns.

Furthermore, Direct-Growth is a superior option. This means you’re not subscribing to Mutual Funds or SIPs through a broker. Hence, you’re entitled to the full dividend value in the form or extra units. However, some Asset Management Companies charge a higher rate for Direct-Growth plans. Yet, the power of compounding works in your favour with Direct-Growth option.

Monthly Income Scheme

Monthly Income Scheme or MIS is a savings plan from India Posts Payments Bank/ Indian Posts Savings Bank. It allows retirees to invest a large sum of money. In exchange, these retirees receive a monthly income or payout that is based on interest calculations.

A common practice among retirees is to reinvest this monthly income on schemes that will fetch high-interest rates. Hence, they also go for Recurring Deposit accounts. The money paid by India Post as monthly income goes directly to a Recurring Deposit account and fetches more interest.

In Conclusion

Public Provident Fund and several other savings schemes in India work on the power of compounding. All you need to do is select the right one for the highest returns. With a little research on interest rates and analysis of the money market, you too can tap the power of compounding and make your money work harder for the highest returns.