Lesson #2
When in school you must have come across various mathematical formula – Algebra, Arithmetic, Geometry, Trigonometry, Calculus, etc.
These formula are profound in their own way and they help us with their application in various aspects of work and life.
However, do you know this formula related to money and finance? It is a formula the application of which has the potential to change our lives.
As the hearsay goes, even a man of the stature of Einstein called it the 8th wonder of the world.
This formula is that of the Compound Interest. The fact that money earns money on itself and thus has the potential to grow at an enormous rate is what compounding is all about.
This is what the formula looks like:
A = P * (1 + r) ^ n
Here,
A means the Amount;
P is the original money that you invest;
r is the rate of interest which you will receive, and
n, is the number of years for which the money is invested.
The two factors that need to be paid special attention to are ‘r’ and ‘n’ of which ‘n’, that is time, has the greatest impact.
Try working it out in a financial calculator or MS Excel.
The magic of compound interest
Compound interest appears to be very common formula. It probably does not receive the attention it deserves. But mind you, its impact is no less.
Talking about money and investments, compound interest grows your money at an exponential rate.
Usually when you make an investment, say Rs. 100 at 10% rate of interest, you receive Rs.10 every year.
But with compound interest, you not only receive this interest of Rs.10 on your investment, but you also receive interest on the interest earned. So, the Rs. 10 of interest earns you another 10% that is Re 1, the next year, taking the total to Rs. 11.
This over a long period of time sets in a virtuous cycle of wealth creation.
Examples:
1. Rs. 2,000 invested every month for 25 years at 10% average rate of return will turn into close to Rs. 27 lakhs.
2. At the same rate of return, Rs. 10,000 invested every month turn into over Rs. 1 crore in just about 23 years.
You see the little trick here. All you have to do is to ensure that you invest your money regularly in a decent option and allow it to be there for a long, long period of time.
You don’t need fancy or complex investments to become wealthy and rich. Just get compounding to work for you.
This is what Einstein said:
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
What do you think?
This note is a part of the free course – Investing 101. Want to subscribe to the full course on email?
