financial planning

‘Compound Interest is the 8th wonder of the world. He, who understands it, earns it; he, who doesn’t pay it!’ – Albert Einstein

Financial planning The word “Interest” in finance refers to the price paid for borrowing money or returns received for landing the money above the principal sum at a particular rate. This interest may be either Simple interest or compounding. When you land the money to any financial institution, simple interest generates the fixed income in terms of percentage for every deposit year on the principal sum. On the other hand in compounding, the interest generated on the principal in the first period is added back to the original principal to calculate the interest for the next periods.

Financial Planning and Compounding is one of the important factors when people talk about money and personal finance. It’s because of the compounding power, the amount received in a year as interest on the deposit is more than the simple interest rate that is given. The most attractive feature of compounding is that it takes the time value of money into consideration which means that by investing in compounding interest-earning instruments, you can generate enough amounts to beat the inflation rate. When you want to earn moderate returns without taking the higher risk, you need to allow the compounding to happen.

The above explanation may seem confusing, so let’s try to understand the magic of compounding with the help of an example. Suppose you are an investor, want to invest Rs 100000 for 10 years duration. You received the proposal from two different financial planning institutions A and B for depositing the amount with them. Institution A will provide a 10% simple rate of interest and institution B will provide a 10% compounded rate interest on your deposit. When you analyze both of the proposals, details will be like this:

Financial Institution A B
Principal Amount Rs. 100000 Rs. 100000
Rate of Interest 10% (Simple) 10% (Compounded)
Duration 10 Years 10 Year
Maturity Amount Rs. 200000 Rs. 259375

It’s implicit from the above table that by investing the same principal for same tenure and interest rate but in two different types of interest rate method, compounding witness real magical power as it will provide 30% more maturity value as compare to the financial institution A. For further clarity, the year-wise break can also be seen in the below table:

Even if in the above-mentioned scenario, financial institution B provides a 9% compounding rate of interest, then also it will generate 17% more maturity value as compare to the financial institution A.

Financial Institution A B
Principal Amount Rs. 100000 Rs. 100000
Rate of Interest 10% (Simple) 9% (Compounded)
Duration 10 Years 10 Year
Maturity Amount Rs. 200000 Rs. 236736

Wealth Compounding keeps the most prominent space in the field of finance and investment. When you let the interest accumulate throughout the duration of your fixed deposits instead of withdrawing it every month, you get a higher amount in the end because of compounding. Mutual funds are most successful in making use of compounding concept. They provide you a “growth” option at the time of purchasing and in this case, profits earned by the scheme are reinvested in the scheme. In this way, they let you feel the real power of compounding. 

“Financial planning for Better future”