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The avalanche effect of compounding interest

Abitha Deepak, BankBazaar.com | January 15, 2009

If you want to attain your weight-loss goal, eat less and exercise more. Well, it's no different when there is money involved. A parallel universal truth with regard to money is spend less, save more, for you to reach your ideal level of wealth.

The earlier you start saving for your rainy day (read retirement) the richer you will be when it finally arrives.

In this context, you need not be a whiz in your attempt to make yourself financially secure for the future. You simply need to be consistent in saving a portion of your money and let it compound over time.

The fascinating effect of compounding gathers up momentum over longer periods of time and becomes an avalanche of wealth.

How does compounding work?

When you save Rs 100 and get an annual interest of 10%, you will have Rs 110 at the end of one year. Due to compounding the next year you will get a 10% interest on Rs 110, which will then leave you with Rs 121. The next year, interest will be calculated on Rs 121 at 10% and so on. In time, these savings will grow exponentially.

There are certain number rules that have been evolved to figure out a quicker method for calculations, especially in finance. Rule 72, is one such quick method of calculating how much time it will take, for your investment to double.

So, if you invest Rs 100 with a compounding interest of 10% per annum, the rule of 72 gives 72/10 = 7.2 years as the approximate time frame required for the investment to become Rs 200.

If you equate the same to a larger amount of Rs 100,000 in approximately 7 years, it would grow to 200,000. Remember you will be consistently saving up too, topping up existing funds, hence, if you are planning to retire 60 years from the time of the investment, it will approximately snowball to about 6 times from its original value. This is the avalanche effect of compound interest.

Fortune favours the early bird!

Compounding interest is like wine, yields better results when money is saved over longer durations. So, if you are planning to save crores (millions) for your retirement funds, then start as early as possible, with your first salary or at least by 25 years of age. So, when you retire at the age of 60, you will be sitting on a comfortable pile of money to lead the rest of your life in style.

If you set aside a sum of say Rs 5,000 every month from the age of 25, at a return interest rate of 10%, in 60 years you will have with you funds worth about Rs 1 crore (Rs 10 million) and more. However, if you start at 40 with the same amount and return rate of interest, the retirement fund will amount to only around Rs 33 lakh (Rs 3.3 million).

That is a huge difference, the 40-year-old individual would need to invest several multiples of Rs 5,000 to be able to catch up!

Here is a comparative chart of the approximate retirement funds an individual can lay claim to depending on the age at which he starts saving.

Let us assume the individual plans to invest Rs 10,000, every year at a return interest rate of 10%. You will realise from the chart that starting early counts a lot!

Age at which the investment begins

Retirement fund

20 years

Rs 49 lakh

25 years

Rs 30 lakh

30 years

Rs 18 lakh

35 years

Rs 11 lakh

40 years

Rs 6 lakh

You will notice from the above comparison that even a matter of five years can make a huge dent on how much you retire with.

You could choose to start saving when you are much older and still meet the target retirement fund of Rs 49 lakh (Rs 4.9 million), saved by an individual who started investing from the age of 20.

However, you will need to increase the amount of money you invest to make up for the lost time. This could be a strain on your budget, as you may have to set aside a significant amount of money to reach your goal.

To illustrate, let's see how much more you would need to invest and at what age, for you reach a target of Rs 49 lakh by the time you are 60 years old. Here is a comparison of the approximate increase in the amounts of money you need to shell out every year to reach your target.

Age at which investment begins

Difference in funds invested

20

10,000

25

16,500

30

27,000

35

45,000

40

78,000

You will notice that the more you delay, the more you need to invest. Hence, it makes sense to consistently set aside about 10% of your monthly income for your retirement fund. This will mean your savings will increase correspondingly with your income, enabling you to grow your funds exponentially.

All you need to reap the advantage of compounding interest and save up a significant retirement fund is to invest time, consistency, patience, and savings to obtain a financially secure future, when you need it the most.

The author is head of content & research at BankBazaar.com.

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