You must have studied the concept of compounding back in school. However, it’s just when you begin managing your finances as a working adult that you understand the value of compounding. Knowledge about the power of compounding not just allows you to earn higher investment returns but even assists you to planyour life’s milestones better. The compounding effect can be better understood through the snowball effect. This is an effect that shows how a little ball of snow builds up to create a bigger snowball as it moves down the slope. The compounding effect works in the same fashion.
With the power of compounding, you can enhance your savings by accumulating higher interest constituents on the returns that you earlier earned. In simpler terms, the compounding effect results in what is called exponential growth where both your interest and account balance grow at an increasing rate with time.
How does the compounding effect function?
The compounding effect is essentially when the interest you earn from the money you invest initially earns more interest or returns for you. So, think about it as interest on interest. In other words, the amount of money that you use for a mutual fund investment, or a fixed-income investment can generate returns from both your initial principal and the accrued returns from the preceding compounding periods. For instance, if you invest Rs 1 lakh in a specific investment plan that offers an annual compounding interest rate of 5% and stay invested for six years, then by the end of the sixth year, your overall investment would be worth around Rs 1.34 lakh.However, had you invested in an instrument without compound interest, at the end of six years, your investment would to a lot lesser since only your initial investment amount would earn interest and not the interest component.
For calculating your benefit from the compounding effect, you can use the online power of compounding calculator from any reliable online financial platform. Doing so would allow you to make an informed decision about the investment amount that you must invest monthly or yearly to meet your financial goal within the required time frame.
How long must you invest to generate maximum benefit from the compounding effect?
As a general rule, the longer you stay invested, the more benefit you get from the compounding effect. That’s because compounding steadily adds to your earlier earnings in each compounding cycle. The minimum investment time frame to really benefit from compounding is over five years, as recommended by most experts. But remember, your decision about your investment plan and investment time frame must be based on your life goals and your potential to invest. Note that the farther your financial goal is, the sooner you should begin investing so that you get adequate time to accumulate your desired wealth.Also, do not consider withdrawing your returns at any time before the investment time frame. Doing so may restrict the growth potential of your investment.
Ending note
To benefit from the compounding effect, you do not need to be a financial expert. You simply have to narrow down investments such as mutual funds that align with your goals and risk appetite and stay invested for the long term. So, don’t procrastinate, start investing today to make the most from the power of compounding.