The Not So Powerful Power Of Compounding

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What is Compounding?


Compounding to basically put it, is making your money earn you money. How? Compounding is the interest calculated on your initial principal (a sum of money) and also on all the accumulated interest it earned from previous periods. For instance, let's say you deposited at the start of the year Rs. 100 into your account which provides you an annual interest rate of 3%. By the end of the year, you'll have Rs. 103. For the next year, you'll earn interest on that new sum Rs. 103.

The Power Of Compounding

"Compound Interest is the eight wonder of the world. He who understands it earns it, and he who doesn't pays it."

Compound Interest is a miraculous thing. It creates a chain-reaction by earning returns on your returns if and only if your money remains invested. Let's see a practical example. Here Earl opts for interest compounded annually, whereas Carl opts for interest calculated as simple interest.

ParticularsEarl Carl 
 SumRs. 100,000 Rs. 100,000 
 Rate10% 10% 
 Time period10 years 10 years 
Amount at maturity Rs. 259,374 Rs. 200,000 
Surplus Rs. 59,374  -

In the above example, Earl is earning interest on the principal sum plus interest accumulated previously, annually. Whereas Carl is earning interest on the principal sum annually. The difference between this simple decision is Rs. 59,374. Don't be like Carl, don't opt in simple interest.

Sounds like a perfect plan for planning out a vacation, or a get-away, or for some emergency-fund, or even for your retirement. Yes, I do agree that it does work miracles. Compounding interest, for me, is one of the very few things that I genuinely like and think is a wonderful concept. It's like a snowball effect, the longer you're patient, the bigger the growth. I, personally, would suggest any teenager to start compounding as soon as they reach the age of 18 (because that's when you can open your own bank account).

So What's Wrong?

 Compound Interest works miracles. It gives anticipated results only and only if YOU DON'T TOUCH THE PRINCIPAL. A lot of people in Nepal save to spend, may it be for buying things, for vacations, for a new bike or a car, etc. So lots of Nepalese fail to be financially stable because we don't tend to have an anchored flow of savings into our accounts. We are saving just for a short period to spend it on some predetermined purpose. There is less to no control at all in the methods of saving and spending in our culture. There are lots of festivals, jatras, needs to showoff, etc. so it's obvious that being financially stable is a myth in Nepal. In other words, a lot of people fail to NEVER TOUCH THE PRINCIPAL.  

This "never touching the principal" is just one intrinsic factor that pushes you away from the paradise of financial freedom. There are lots of other external and internal factors that kill the power of compounding. To name a few, we have income tax, changing rates, inflation, discouragement from low rates, impatience, economic instability, consumers' price index, etc. 

 For instance, let's talk about inflation.

    Inflation is increase in the general price level of goods and services in an economy over a period of time. In other words, inflation is money losing its purchasing power. The anticipated inflation rate in Nepal for the fiscal year 2020-21 is around 6% which can be perceived as high as compared to our neighbouring countries. The usual interest rate banks provide is around 3 to 5 percent. Let's take an average of 4. Now if we invest a sum of Rs. 100 at the start of the year, we will get Rs. 104 by the end. But the same Rs. 100 would be inflated by the end of the year, which means Rs.106 would be the new Rs.100. So when we look on this case, we might think by the end of the year we earned Rs. 4 but actually we lost Rs. 2 due to inflation. 


This is just one factor that affects interest. There are other complex stuffs that matters when we opt in for compounding interest. Therefore I think the Government should include basic personal finance education in school levels.

If it's complex, it's no fun. Actually it's not that complex either. We just have to keep in mind the most important principle that is "Compound Interest is good as long as the interest is on our side". It will KILL YOU if you're the one paying the interest, that is that you borrowed money. It's great if you're regularly saving money, but it WILL KILL YOU if you're borrowing money. It's a double-edged sword.



Comments

  1. Locksmee GurungJuly 2, 2020 at 8:50 PM

    I love what this article has to say ...thank you for this!!!

    ReplyDelete

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