Understanding Compound Interest: A Comprehensive Guide | Spring Money

“The best time to plant a tree was twenty years ago, the second-best time is now”.

This ancient Chinese proverb best illustrates perfectly how long-term financial security and wealth and is actually built, and we’ll let you in on a secret. It has absolutely nothing to do with picking the perfect stocks and timing the markets flawlessly but has everything to do with your patience and confidence.

Sounds a little counter-intuitive, doesn’t it? With the magnitude of a task like managing to ace your stock picks consistently over a long period of time, you’d think the reward for that would be higher than sitting and watching, but surprisingly, it's quite the opposite! The reason for this is due to a funny little principle known simply as “compounding”.

So, what is compounding?

Imagine a little snowball, being rolled down a hill. At the beginning, the ball will be small, as it comprises of a minor amount of snow. But as the ball rolls down the hill, it picks up snow from the ground it is being rolled on while also picking up speed and surface area, allowing it to grow much larger much faster as the ball keeps rolling.

Compound interest works very similarly to our little snowball, as time progresses, the amount compound onto the original sum also grows. In the first year, interest is added onto the original sum, the year after that, interest will be added to the capital with the previous year’s interest included, and the third year’s interest will be added to the sum of the capital and the first 2 year’s interest amounts and so on. These amounts remain small increments for the first few instalments, and then gradually transition to exponential increases as time progresses.

How is it different from simple interest?

Simple interest and compound interest are two strikingly different concepts, but both serve the same purpose. Let’s observe the differences in their characteristics and observe examples of both:

In the concept of simple interest, a set amount of the principal amount will be added to the current amount, regardless of how many increments have already taken place.

The concept of compound interests works very differently, as each year’s interest is added to the amount derived from the previous year’s interest rate added upon the principal amount.

Let’s understand this through the case of Sita and Gita.

They both have Rs. 10,000 worth of assets which increment at 10% per year, but Sita’s asset is set to compound interest while Gita’s will follow the principle of simple interest.

At the end of a 5-year run, Sita will have Rs. 16,105 while Gita will have only Rs. 15,000 despite having the same interest rate. But this discrepancy will only increase with time.

Even if Gita had a 15% P.A rate while Sita maintained her 10% rate, over a 20-year period Gita would have merely Rs. 40,000 while Sita would have Rs.67,275.

And this is how the earlier discussed “snowball” method operates, Sita’s amount grew larger because every year, her interest was added onto the existing total balance. While Gita’s was only added at a fixed rate, regardless of how much her current amount was. Here is a representation of how these two concepts progress on an incremented amount, their common rates being 10%:

Simple interest:

10,000 -> 11,000 -> 12,000 -> 13,000 -> 14,000 -> 15,000 -> 16,000 -> 17,000 -> 18,000 -> 19,000 -> 20,000

Compound interest

10,000 -> 11,000 -> 12,100 -> 13,310 -> 14,641 -> 16,105 -> 17,7,16 -> 19,487 -> 21,436 -> 23,579 -> 25,937

Here we can observe the different incrementing patterns these two systems follow; simple interest follows a linear progression with a common difference due to the interest rate being applied to the principal only. Whereas in the case of compound interest, there is no common difference as the interest is added onto the sum of the

principal and earlier applied interest amounts.

This varying progression model gives compound interest the edge over its simple counterpart and earns it the nickname of the “eighth wonder of the world”, dubbed by Albert Einstein. Understanding it is instrumental to the long-term building and preservation of wealth, and only he who understands the effective application of compound interest will be able to generate wealth effectively.

Also, just in case you're interested about where Sita and Gita will end up after 25 years, if they continue with the same trend, you'll realize how much the impact could be over such a long term. While one stays at Rs. 35,000, the other would go up to Rs. 1,08,347, which is more than thrice the amount.