Compound Interest – The Eighth Wonder of the World

Wealth creation is mainly dependent on a couple of factors i.e., time and return. While higher return leads to more wealth in the future, there is one more factor that isn’t often talked about i.e., time. It’s better to start saving earlier than later. The reason is the compounding effect, the most important factor in investing.

Compounding helps you get an exponential return on your investment. This is because you get the interest on not just the principal amount but also on the interest that you have earned over the years.

For example, if you own $100 and you get the interest at 10% per annum, you will have $110 after a year. The next year, you will have $121 because of the compounding effect. This process continues until your original $100 is eclipsed by the amount of interest that you’ve gained.

The figure given below will help you understand how the compounding effect has the power to provide you with returns even greater than the original amount that you have invested.

It is important to note that time has a major impact on compound interest. The longer the time an amount remains invested, the higher would be the final amount earned. This can be seen in the above figure, where the return on $100 after 20 years is significantly less than the return after 30 years.

The rate of return is the second most important factor in compounding. For example, there isn’t much difference between an 8% and 10% return in a year, but the difference will be huge after a significant period.

The following figure will help you understand the difference in return of 8% and 10% on $100 invested for 30 years.

It is clear from the above chart that while $100 invested at 10% for 30 years gave a return of $1,800, the same amount will become only $1,000 after 30 years- that’s a difference of $800. The difference would be even greater for bigger amounts.