Yo! What’s up!
Welcome to Episode 7 of my Little Saves Podcast on Personal finance. Every Tuesday we look at one interesting aspect of money and personal finance. Today, I am going to talk about a very common, yet underrated concept in the world of Personal Finance. It is the super-duper, hot and sexy power of compounding.
The story of Benjamin Franklin and his trust
Let me start with a small story. Have you heard of Franklin Templeton. Good, but no, this is not about him. This story is about Benjamin Franklin. He was a multi talented smart dude who is one of the founding fathers of the United States of America.
The story goes that after his death, he had left a sum of $4400 to the State of Boston and Philadelphia. He had just one condition. The money was not to be touched for a period of 200 years. Good old Franklin kicked the bucket and a trust was set up in 1785 to manage this money. Over the years, the cash continued generating interest and that kept compounding. After 200 years, around 1990, the value of this $4400 came to about $5 Million per state. Yes, $4400 over a period of 200 years amounts up to $5 Million with no further addition of money. Purely on interest alone.
That my friends is the amazing power of compounding interest. Over a period of time, with continuous compound interest accumulating, $4400 can become millions if the accounts is let alone to compound.
Compound Interest definition
The concept of compound interest is quite simple. When investing, you put some cash in the investment account that generates interest. This interest can be monthly interest, daily or even annual interest. The key point is, when interest is earned in one cycle, in the next cycle, along with interest for your principle, you also earn for the interest you earned in the earlier period.
This can become a steady stream of passive income for you.
To give you an example of what is compounding money, say you got Rs.100 in a fixed deposit with the annual interest rate at 10%. For the first year you accumulated interest is Rs.10, that is 10% of Rs.100. So now, after one full year, you have Rs.110. In year two, when your interest is due, you will not be eligible for earning an interest on Rs.110, that is your initial Rs.100, plus the cash paid previously, so you will earn Rs.11, that is 10% of Rs.110.
On the other hand, if you invest and get simple interest instead, for this Rs.100 you will be getting Rs.10 annually. On year 1, you have Rs.110 and on year 2 you will have Rs.120. In simple interest, the interest you earned earlier does not earn interest for itself.
As your investment keeps going and time passes, the fund you invested keeps generating interest and every year, the interest generated gets more interest. This is what compounding means. Compound interest plays a big role in your investment strategy and means a lot in retirement.
Haters continue to hate
Well if you are a cynic, you will probably dismiss this story saying “I am not going to be living for 200 years. So why bother!”. On the other hand, optimists like me would be crunching numbers, seeing how to utilize this within our own short lifetime!
Money and the interest earned on it can compound over any period of time. It can be 200 years or just 2 days. You do need a longer time to earn more, but don’t let that make you lose your enthusiasm.
Let’s look at a few ways on how you can use this when planning your own financial strategy.
Start small, save often
If you ask me when is the best time to save, I would say it is 24 hours a day, 7 days a week and 365 days a year. Save often, save as much as you can and save till you start feeling the pinch. You know you are saving enough when you start cutting back on expenses since you are short of cash and your cash has already gone into savings. Even 10 rupees or a dollar here and there over a period of time and with some extra push due to the compounding effect on the interest can get you a substantial amount of money.
Plan wisely and follow through consistently
Set your goals and follow up on them consistently. If you take a pledge to save 1000 bucks a month, make sure you do it every month.
If you open a Fixed deposit that gives out 8% interest, put in Rs.1000 into it and let it stay there for 20 years, at the end of 20 years you will have Rs.4,960.
Now, instead of just 1000 initially, say you keep adding Rs.1000 to it every month, by the end of 20 years, you would have added Rs.1000 240 months, that is 2,40,000. But the actual money you will have is Rs.5,99,000. More than double. Now, increase that to Rs.5000 a month and in 20 years, you would have invested Rs.5000 240, which is 12 Lakhs, but you get a total of Rs.30 Lakhs at the end of 20 years.
Think how great it would be if you had been squirreling away 5000 bucks every month from the time you started earning to now. If you are middle aged, you would probably be able to close your home loan with that money!
Check out how much you get with our compound interest calculator here
Money saved to compound vs other options
Now, compounding happens when you have money earning interest. And then the interest earned earns interest and so on. This is not the only way to make money grow. You have other investment options such as stocks, gold, real estate etc all of which have their own pros and cons. Some may give higher returns and may have larger risks. Deposits is one of the safer, less risky option if your money is with a large, trustworthy bank, backed by the government.
Your investment strategy should not be all about getting the highest of returns. You should also think about getting it consistently and diversifying. That way, some amount of your savings should definitely go into a deposit scheme that steadily grows over a period of time.
That’s it for today folks. In the next episode, coming up next Tuesday, we will be looking into the concept of Geo-arbitrage! It is a brilliant way to save money and extend your retirement period. Till then, stay tuned and check out littlesaves.com for more on personal finance. Bye bye.
Read about the effect of inflation on your investment here.