Compound interest- The reason to start saving today

One of the most important dreams of children and young adults is about growing up and start earning so that the amount can be spend as per wish.  Majority of the readers might have dreamt about receiving salary for the first time and gifting it to parents. Some of you might have thought about spending one full day in a big shopping mall fulfilling all dreams of dining, playing and watching movies
Have anyone ever thought of saving a portion from the first month itself? Many might not have. The importance of saving can be realized if you look at your parents, how they are working every day and saving a portion of their earnings for sending you school and meeting medical treatments and other exigencies.

Saving habit is one of the most important habits that each child should practice from childhood.  Today, banks, post offices and other financial institutions  offer special accounts for children to teach them the habit of saving. There are different products like savings bank account, recurring deposits, fixed deposits etc to choose from. 

Compound Interest

Along with saving, you often hear the terms simple interest and compound interest.  Interest is the periodical compensation you earn till the amount is repaid, for parting your amount to somebody for meeting his financial need.  The advantage of compounding interest is that you earn interest on both the principal amount and interest accrued. 

You have learnt the formula  I= PNR and  〖I=P(1+r)〗^n , for simple interest and compound interest respectively.  You might have solved many problems using the compounding formula. But, it is possible that you would not have noticed the real power of compounding.

The statement “Compound interest is the eighth wonder of the world. He who understands it earns it…he who doesn’t … pays it”, amply reveals the potential of compounding interest. The quote is often attributed to Albert Einstein, who was an expert on the various powers of the universe.

Let us learn about the power of compounding and how the compounding effect helps to accumulate our wealth.   

Anton, John and Paul are three friends. All are 25 years old and are getting their first salary today.  Their retirement age is  60 years. They have decided that they should have  Rupees One Crore each at the time of reaching age 60. They have also identified an account that pays interest at the rate of 8% per annum compounded quarterly  for the next 35 years. Since it is compounded quarterly, interest is paid on the accumulated interest also every quarter. 

Anton was brilliant in mathematics and has learnt about the effect of compounding and he starts saving today itself by investing every month.  John  wants to save but he decides to spend whatever he earns till reaching 40 years of age. Paul on the other hand is an easy going person and he decides that savings for retirement need to be started only after reaching fifty.  

Amount to be invested to receive Rupees One Crore at the age of sixty.

Starting age

 

Years (A) till reaching 60

Months (B) till reaching 60 –Ax12

Monthly amount (C)to be saved by Anton

Monthly amount (C )to be saved by John

Monthly amount ( C ) to be saved by Paul

25

35

420

Rs.4,387

—–

—–

40

20

240

—-

Rs.16,976

—–

50

10

120

—-

—–

Rs. 54,461

Total amount deposited

P= BxC

—–

—–

Rs. 18,42,540

Rs. 40,74,240

Rs.65,35,320

Amount at the age of 60 -Q

—–

—–

Rs. 1,00,00,000

Rs. 1,00,00,000

Rs. 1,00,00,000

Interest earned- R (P-Q)

—–

—–

Rs.81,57,460

Rs. 59,25,760

Rs. 34,64,680

 

By saving an amount of Rs. 18,46,540 over a period of  35 years, Anton earns rupees one crore. But due to delay in starting to save, Paul has to deposit  3.54 times more than  Anton to earn the same amount.  In the case of Anton, the interest earned is 4.42 times the investment where as in the case of Paul, the interest earned is around 50% of his investment.  That is the power of compounding.
Now,  let us examine how much will be the  amount at the age of 60, if Anton , John and Paul  starts saving  uniform amount of Rs. 5,000 each per month  at  the ages of 25, 40 and 50 respectively.
              

              Amount received at the age of 60, if the amount saved is Rs. 5,000/- per month. 

Starting age

 

Years (A) till reaching 60

Months (B) till reaching 60 –Ax12

Anton

John

Paul

25

35

420

Rs.5,000

—–

—–

40

20

240

—-

Rs.5,000

—–

50

10

120

—-

—–

Rs. 5,000

Total amount deposited

P= BxRs.5,000

—–

—–

Rs. 21,00,000

Rs. 12,00,000

Rs.6,00,000

Amount at the age of 60 -Q

—–

—–

Rs. 1,13,96,984

Rs. 29,45,248

Rs. 9,18,084

Interest earned- R (P-Q)

—–

—–

Rs.92,96,984

Rs. 17,45,248

Rs. 3,18,084

 

Let us examine the effect of monthly, quarterly, semiannually and annually compounding.  We are examining the case of  Anton alone.

Impact of Compounding frequency

Starting age

 

Years (A) till reaching 60

Months (B) till reaching 60 –Ax12

Total investment

B x Rs. 5000

Maturity amount for monthly investment of Rs. 5,000/- each at 8% interest with different compounding periods

 

 

 

 

Monthly

Quarterly

Half Yearly

Annually

25

35

420

21,00,000

1,15,45,875

1,13,96,984

1,11,82,328

1,07,81,765

35

25

300

15,00,000

47,86,833

47,45,793

46,86,297

45,74,197

45

15

180

9,00,000

17,41,726

17,33,533

17,21,594

16,98,892

55

5

60

3,00,000

3,69,834

3,69,309

3,68,542

3,67,070


Based on the above, examine whether the following statements are true or false. 


 1.More the period less the amount to be invested to achieve a specific corpus. 
 2.Lesser the compounding frequency, more the maturity amount.
 3.We get better maturity amount , if we save regularly.
 4.The impact of return depends on the amount of investment, period of investment, rate of interest and compounding frequency. 
 5.The best time to start saving is now. 

If you agree that all the above statements are true, you have learnt the potential of compounding interest.  Go ahead, start saving TODAY. 
                                  

     John CS

 

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Summary
Article Name
Compound interest- The reason to start saving today
Description
Along with saving, you often hear the terms simple interest and compound interest. Let us learn about the power of compounding and how the compounding effect helps to accumulate our wealth.
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