What is compounding and how does it work?

Compounding is a process in which the interest earned is added to the principal and re- invested. Further interest is calculated on the reinvested amount i.e., principal plus interest. Compounding means getting interest on interest.

Simple interest can be defined as the interest earned only on the principal amount for a given period of time. It is calculated as per the below given formula –

Simple interest = P*R*N

P = Principal,

R = Rate in percent (5% means 5/100)

 N = No of years

Compound interest is calculated on the revised principal after adding the previous interest. In this process the principal amount keeps on increasing because the interest earned will also become a part of principal amount for further interest calculation. The basic formula to calculate the compound interest is –

C.I. = Principal (1 + Rate)Time – Principal

Real life example of power of compounding with illustration

Let’s see the power of compounding for Rs 1 lakh at the rate of 10% annual: 

Amount (Rs)Rate of interestYearSimple interestCompounded interestDifference
10000010% annualAfter 1 year10000100000
After 2 years20000210001000
After 5 years500006105111051
After 10 years10000015937459374

The above given example shows how compounding helps in creating wealth with time. There is a significant difference in amount earned as interest. Compounding is the key factor of this difference and it is due to its multiplier effect.

Power of compounding acts similarly in the mutual fund investments also. A smart investor can take maximum advantage of compounding by initiating an early investment in suitable mutual fund schemes for a longer duration.