Explained: How The Concept Of Compound Interest Applies To Investing

While compound interest can work for you and multiply your investments, it can also lead you to financial burden

Imagine there's a constant drip feeding small amounts of money into your investments. And over time, if you allow it to grow, the money you receive at the end of the term could really add up. To benefit from compounding, you need to reinvest the dividends and stay invested for as long as possible.

Suppose you invest ₹10,000 into a new stock. In the first year, the stock prices rise by 10%. You now hold an investment worth ₹11,000. Since the stock shows good performance, you continue to hold onto it. In the second year, the stock prices appreciate further by another 10%. So now, the ₹11,000 have grown to ₹12,100. Instead of the stock appreciating another ₹1000 [10%], like it did in the first year, it appreciated another ₹1100 because the ₹1000 you had gained in the first year also grew by 10%!

Now, if you stay invested for 25 years with an assumed interest rate of 10% per annum, your original ₹10,000 would grow to nearly ₹110,000 — without adding any more additional money. For the power of compounding to act on your money, it requires three things from you. They are:

  • Allow the original investment to stay invested
  • Reinvest your earnings
  • Give your investment time

So while the examples are hypothetical, and actual returns could differ, you get the picture of how compounding applies to investing. The more time you let your investments to stay put, the more you could benefit from accelerating the income potential of your original capital.

Also Read: Explained: All You Need To Know About Compound Interest

How to leverage the power of compound interest?

If you're looking to grow your wealth, you need to leverage compound interest effectively.

Since compounding interest can increase your investments, it also has the potential of increasing how much you owe when it comes to debts.

Here's how you can empower your money through the power of compounding.

  • Invest as soon as reasonably possible
  • Investors regularly and avoid you do not skip on your systematic investment plan [SIP] investments.
  • • Allow your investments to rise exponentially larger with ample time to grow and compound.
  • Stick to a long-term investment strategy to reap the power of compounding.
  • Keep yourself from falling into the debt trap by assessing your budget and paying off high-interest rate debt on time.
  • Reduce the effect of compounding on your debt by paying down the balances on your credit card faster

Also Read: What Is Goal-Based Investing, How Can It Help You Create Wealth?

The dark side of compounding

While compound interest can be an exceptionally powerful tool to have in your financial arsenal, the darker side of compounding interest is that it can compound debt by incurring interest on what you already owe.

So if you don't have a reasonable repayment plan, compound interest on your debt can spiral out of control and burrow you deeper into the debt hole.

But there are ways to release yourself from the dark side of compounding.

  • Get out of high-interest rate debt as quickly as possible
  • Considering a more subdued lifestyle
  • Refinancing or consolidating all your debt through a balance transfer.
  • Introducing regular investments to get out of the cycle of compounding debt

Myths around compound interest

Myth: Compound interest and investing early always gives you more money

You've heard this time and time again: invest as soon as possible to profit from the power of compound interest. It's actually a myth. That's because, if you have debt, compound interest is solely working against you.

You need to consider your individual circumstances and understand how compounding interest is working in your financial scenario. For instance, if you have a consumer debt at skyrocketing interest rates, it's basically draining money from your account than a risk-free investment, earning you meagre interest. So when regarding compound interest, look into paying off high-interest debts first.

Myth: Invest in the stock market because of compounding interest

Fixed-income investments such as bonds pay interest. Stocks do not. So if somebody informs you that the stock market is making, say, 10% per year, saying you could benefit from compounding interest, you're being misled. Here's how it plays out.

When somebody tells you that you could earn, for example, a 17% interest in the stock market, they don't tell you that most of those returns are from dividend reinvestment. So you need to look into stocks that are paying high dividends. But if you are young and probably don't know much about how the stock market works, you may be told that you should take more risk. And more risk means focusing on investments that don't pay dividends.

Ideally, going in for a Systematic Investment Plan [SIP] in mutual funds for the long run is where you can truly benefit from the power of compounding, as your gradual investment keeps on growing and benefits from averaging.

Also Read: Explained: 7 Thumb Rules For Investing Every Investor Should Know

This story is a part of BOOM Money's series on personal finance.

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