Manage Money

Compound Interest and Its Benefits

What is Compounding or Compound Interest? What’s so great about it such that even one of the greatest minds on the planet sang its praises?

Don’t worry. It is not rocket science, and once you understand it, you'll know how it helps you save and even earn passive income. That’s right, passive income: the income you make while you sleep. 

Compounding means getting an increase on the value of your investment due to interest earned as well as on the accumulated interest. 

Compound interest actually means earning interest on interest. What happens is this: each time you get interest on the principal amount, this interest is added back to the original existing amount. This in turn becomes your principal. This goes on and on, and thus, you keep on earning more every time. In a way, it is passive income.

Consider a snowball rolling down the side of a mountain. At first, the snowball is nothing to worry about. But as it rolls down, it accumulates additional snow and ice. It gets bigger and bigger the more it rolls down. Compound interest is like that. 

In compound interest, the interest is earned on both the interest and on the principal previously accumulated. This repeats itself, which enables you to get much more value at investment’s maturity.

Now that you know and understand the basics, it is time to learn about…

3 ways to get the most out of Compound Interest

You know the basics of how compounding works. Great!

It is now time to learn about how to use it to your best advantage. 

The three rules are: 

Understanding compound interest smartly

It is important to understand how it works because it can backfire pretty easily. If you don’t understand how your savings grow, it can make your credit or loans grow in the same way. That means unless you are careful, your loans and credit card debt can accumulate compound interest, which means you’ll have to pay a huge amount to close such loans and credits. 

Compound interest is the 8th wonder of the world. He who understands it, earns it. He who doesn't, pays it. - Albert Einstein

For example, you borrow Rs. 1000. In time, the amount increases, which means you’ll have to pay more than the original amount to close your loan.

This is why it’s so important to control all your credits, loans and borrowings. The best thing to do is to pay back as soon as you can. 

Longer is better

When it comes to compound interest, longer is better. 

This means the longer your investment is, the more your returns you’ll get. A lot of people start withdrawing money as soon as the first batch of interest comes down. Had they understood the concept of compound interest, they would not have done that. If you are still tempted to take out money from your account, we do advise that you keep your investments for the longest period of time possible.

Additionally, you should start saving as early as you can. For instance, if you start investing from the age of 20, and if a friend of yours started investing at 30, you have more time to benefit from. 

Keep track of your interest rates

With compound interest, an essential thing to do is to keep track of interest rates. There are several avenues for investing in, all of which have different interest rates and varying levels of risks. Take your pick from what suits you best.

Different securities 

Interest rates 

Bank-based savings account

4 - 5%

Debt funds

7 - 8%

Equity-based mutual funds

12 - 13%

Shares 

15 - 16%

Why should you pay close attention to interest rates? 

This saves you from paying more than what you should have to. Additionally, you need to take tax into account as well when calculating your returns. You should also pay attention to the amount that is getting compounded. 

Besides all these rules, an investor should also be disciplined and have patience. 

To conclude

It all comes down to how to apply all this knowledge. Using these tricks, we hope you’ll have a great financial future with compound interest.

 

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