"If we command our wealth, we shall be rich and free. If our wealth commands us, we are poor indeed." - Edmund Burke, 18th century Irish statesman, author, political theorist and philosopher.
Albert Einstein called compound interest "the greatest mathematical discovery of all time". Why do you think one of the most intelligent men of the 20th century thought compound interest was so important? In money terms, compounding refers to the process where interest that you earn is added back to the investment pool so it also starts earning interest in the future. Compounding basically transforms your money into a potent income-generating tool. Let's see how compounding works with a simple hypothetical example.
Consider two people, Riya and Kabir. Both of them are 35 years old and started working 10 years ago at the age of 25. Riya made a conscious decision to save a part of her income from day one. She put aside 10,000 every month and started earning 10% interest per annum on her savings, compounded monthly. On the other hand, Kabir felt that he was still young and had plenty of time to think about financial planning. When he turned 35, he decided it was now time to start investing for his retirement. He also managed to save 10,000 every month, just like Riya.
Now fast forward 30 years to when Riya and Kabir are about to retire at the age of 65. Both of them have been consistently saving 10,000 every month and earning 10% on their investments. Since Kabir started 10 years after Riya, he was able to set aside 12 lakhs less than Riya. But can you guess what the difference in the final balance of both their investment accounts is?
The answer is 4,00,00,000! No, we did not accidentally type a few extra zeros. The fact is that, by now, Riya's investment account would have roughly 6.30 crores balance while Kabir's account would have 2.25 crores, a total difference of over 4 crores. Here's another way to look at it – if Riya had completely stopped saving by the time she was 35, she would still end up with more money than Kabir!
Still not convinced? Take a guess on what Riya's investment balance would be if the interest she was earning didn't get compounded. The right answer is 1.43 crores. You read that right – compounding helped her earn more than 4-times what she would have earned otherwise. And that, my dear friends, is the magical power of compounding.