A phone call between two friends leads to a conversation on how compound interest works.
Karthik: If not for Covid-19, we would have planned a trip this December, no? Phew!
Akhila: How I miss travelling!
Karthik: The silver lining is that I’ve saved a few bucks from limiting my travel this year.
Akhila: So, are you planning to invest that money?
Karthik: No, yaar! It’s too little to invest. Even if I do, the interest I earn on it will be peanuts.
Akhila: No, you’ve got it wrong. The return that you may earn today may be small, but if you stay invested over a long term, the power of compounding will result in bigger gains.
Karthik: The word compounding rings a bell. Care to explain?
Akhila: Sure. As Benjamin Franklin explained compounding: “Money makes money. And the money that money makes, makes money.”
Karthik: Whoa! Sounds like a tongue twister! Explain it in simple terms, no?
Akhila: When you invest, your principal amount earns interest in the first year. In the next year, you earn interest on the principal as well as on the interest earned in the first year. In the following year, you earn interest on the principal and on the interest earned in the first two years and so on.
Karthik: – That’s amazing!
Akhila: – To give you some perspective, any amount invested at 10 ten per cent per annum takes about 10 ten years to double if the interest is credited based on simple interest. But if the interest is compounded yearly, the investment doubles in just about 7.3 years!
Karthik: – Interesting…
Akhila: That’s the miracle of compounding. So, will you invest now to unlock the value of compounding in the long run?
Karthik: Of course! I have been waiting all life for a miracle to happen. Never thought it will be through compounding.
Akhila: Good! But, you also need to remember that compound interest can also be your greatest enemy.
Akhila: That is when you do not repay your loans on time. Any interest on your loan, if not paid by the due date, attracts interest. If the dues are not paid for a long period, the outstanding loan amount can snowball into a mountain of unmanageable debt.
Karthik: Real killer.
Akhila: As the popular saying goes: “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Karthik: That’s Simply Put.