Magic of Compounding.

Early birds catches warm first. We have been hearing this phrase since our childhood. The message is very simple; if we start early we may save more. How much should you save? There is no perfect answer to this question; however, we should save as much as we can, without adversely impacting the quality of our life. It is particularly important for young adults to have savings because they are in the beginning of their financial lives. Young couple has a tendency to forego the early retirement savings, but catching up later on can be incredibly punishing and the longer they wait, the more punishing it gets. Young couples who are in their accumulation phase (age between 25 to 40) where even a small amount of regular saving will have larger impact in the long run due to the power of the compound interest. Compound interest will help us to reach our savings goal, even with low expected returns. The concepts apply for savings towards any goal, such as retirement, purchasing a home, or saving for an education.

Concept

In general, we place our saving with bank to get certain amount of return. The return that we receive form our bank account is interest. Based on the calculation mechanism; interest rate can be classified in to following two ways.

• Simple Interest: Simple interest is when interest is only charged on principal that is, the original amount of the debt or investment. For instance, if you deposit money into a bank account that pays only simple interest, it will only pay you interest based on the original deposit amount. It will not pay interest on the additional funds in your account that came from its interest payment.

• Compounding Interest: When the interest rate is applied to the original principal and any accumulated interest, this is called compounding interest. When compounded interest is applied, interest is paid on both the original principal and on earned interest.

Lets’ look at the two examples to understand the benefit of compound interest

Example 1

For clear understanding of the compounding effects, let’s work out on bank account which offers 5% p.a. interest rate in deposit and has assured to keep rate constant at least for the first 10 years with the term of withdrawal prohibition. In the meantime applicable TDS also has assured to pay by bank side. Similarly let’s suppose other applicable things will remain unchanged. Viewing the offer of the bank Mr. Ram who has initial ideal fund of NPR 1,000 intends to open bank account with that fund. Now, let’s see what would happen during 10 years of fund deposition. Mr. Ram will earn NPR 50 as interest income during first year which is simply the product of initial deposit amount and offered interest rate (i.e. NPR 1,000 x 5% p.a.) which also be known as simple interest calculation.

Now, if the earned interest (i.e. NPR 50) is directly deposited in the account of Mr. Ram than what will be the worth of available fund in the account maintained with the bank? Obviously, NPR 1,050 will be the volume of deposit available in the account. Let’s look at table 1 below.

As shown in the table above, if NPR 50 is also kept in the account than NPR 50 will also earn interest of NPR 2.5 (i.e. NPR 50 x 5% p.a.) along with the regular interest earning of NPR 50 (i.e. 1000 x 5% p.a.) making total interest earning of NPR 52.50. If we look meticulously in the occurrence, we will find upward deviation on interest earning due to the presence of previous interest earning posted in the account and interest earned on previous interest earning is the corner stone for the upward swinging outcome. In financial mathematics such phenomenon are known as compounding effects. Especially for the wealth maximization process compounding effects play very important role. Following process as shown in the table of deposit increment from NPR 1,000 to NPR 1,628.89 signifies the glory of compounding effects.

If we compare the return based on both interest rates, i.e. simple and compound, the result is surprising. The return from simple interest rate is only Rs. 500 (i.e. 1000*0.05)= 50 per year and total Rs. 500 in ten years. Whereas it is Rs. 628.89 due to compounding effect. Note that, the above calculation is under the assumption that the interest is paid on annual basis. However, if the interest is payable on quarterly basis (which is the practice in Nepal by banks), the initial deposit of Rs. 1000 will be around Rs. 1,643 which is greater than Rs. 1628.89. Compounding works best when the interval of compounding is shortest i.e. quarterly is better than half yearly or yearly. This is because the earnings in the form of interest are re-invested more frequently and made to participate in future growth.

For the simplicity purpose, we only took Rs. 1,000 for the example and assumed that Ram’s deposit of Rs. 1000 will remained the same throughout 10 years. However, the difference and advantage will be much larger if Ram starts depositing Rs. 1,000 each month (i.e. 12,000) per year. Rule of the thump is; regular deposit even a small amount will provide larger benefit in the future due to the compounding effect.

Above example illustrates the benefit of compounding. Now let’s look at the benefit of early saving from the example 2 presented below.

Young couple has a tendency to forego the early retirement savings, but catchin up later on can be incredibly punishing and the longer they wait, the more pusihing it gets.

Example 2

There are two twins brothers Anil and Sunil. Anil started to save from the age of 26 years till 35 years. He did not withdraw till he reached 60. Sunil started saving at 36 years, but continued till 60 years. Both saved Rs. 50,000 per year and earned 10% p.a. on their investments. We need to find answer of the following questions.

• Who would accumulate more at 60 years of their age?

• What amount?

• How much difference in accumulated amount?

Once we carry out the calculation, the result is surprising. Anil saved Rs. 8.6 million whereas Sunil saved Rs. 4.9 million. In spite of saving more money Rs.1.25 Million against Rs. 0.5 million, Sunil ended up with less money at the retirement. The most important is the difference of the saving (i.e. 8.6 million versus 4.9 million). Anil saved Rs. 3.7 million more than Sunil. The reason is very simple; Anil started saving early than Sunil and off-course, compound interest played role to increase the wealth.

Conclusion

The moral of the story is start saving early and even with very small amount. In a lot of instances; young people are not thinking of investing, they rather use their surplus fund in consumption. In other cases; some believe that small investments are not going to do much for their future. This is a very wrong perception. Small amount a month will convert into larger saving when we accumulate it in yearly basis with compound interest.

When we are trying to establish ourselves in a career during our twenties and thirties, we may not have long-term goals, but that should not make us discard the savings process. We need to realize that along with our lifestyle expense, the savings can also go hand-in-hand. The ‘investing can wait’ attitude needs to be overcome to take the maximum benefit of compounding effect. Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn’t ... pays it.” Therefore, let’s start saving early to get maximum benefit of compounding in the long run.