Role of Compound Interest in Wealth Generation

The term `Compound Interest’ is a very well known and common term in the world of finance and even to common man. However, its importance is rarely felt and recognized. Two things that are required to maximize the power of compounding are `time’ and `patience’.   It is the most important concept in the domain of wealth creation.

What is Compound Interest ?

When interest is applied on the interest earned previously then it is said to be compounded. A small illustration will help to understand the concept clearly.

Let us assume Rajini gives his two sons Vijay and Ajith Rs 1 lac each. The two sons go to a Bank to invest the same for a period of 10 years. The Bank gives the following options for them to choose:

Option A: 10% interest to be paid out at the end of every year for 10 years.

Option B: 10% interest will not be paid out every year but would be reinvested (re-deposited) again.

Ajith chooses Option A and Vijay chooses Option B.

Now let us look the portfolio of Ajith and Vijay

The total interest earned by Ajith is Rs.100,000, whereas the total interest earned by Vijay is Rs 159,374. Vijay’s wealth is more by 59% compared to Ajith’s wealth.

Maximising the power of compounding :

The growth of wealth on account of compounding becomes exponential as the time increases. In other words the power of compounding would be very effective if the savings are begun at an early stage. Let us continue the above example further for a period of 25 years.

Compound Interest

The blue bar represents the interest paid out amount which is constant every year. The red bar represents the compounded interest. See the exponential growth of the red bar as time progresses.

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Author and Assistant Professor in Finance, Ardent fan of Arsenal FC. Always believe "The only good is knowledge and the only evil is ignorance - Socrates"
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