Lets understand, what is compounding and what is the hype around it ?

Assume you have 1 Lakh rupees in your hand which can be invested and there are couple of options you have, where this money can be invested –

1. Fixed amount which LIC (or similar company) offers you to return after 10 year – 1,60,000.
2. Invest in the fixed deposit which promises you simple interest of 1 Lakh at 7% for 10 Year
3. Invest in the fixed deposit which promises you compound interest of 1 Lakh at 7% for 10 Year

Let see now, how the return in all the 3 options will looks like after 10 years –

Did you noticed, which option will provide you the best return ?

Yes, its compounding interest i.e. Option 3, which will give almost 2x the money invested, far much more than the fix amount of 1,60,000 and more than the simple interest option of 1,70,000.

Now, if you increase the time to 20 years, and see the real magic of the compounding.

In option 1 your return will be 2,20,000, In option 2 your return will be 2,40,000 but in Option 3, it will be 3,86,968.

So, how does this happen and how it works –

It is fairly simple – In compounded interest, your interest earned in the 1 year becomes the base of the interest calculation in the next year i.e. 7% was calculated on 1,00,000 in 1st year then 7% will be calculated on 1,07,000 in the next year and so on. It is hard to imagine that how it adds up over a period of time and gives a huge return at the end of the investment period. See following table on how the math will look like on year on year basis –

You may heard the from various people or on TV advertisements etc., that let your money compound in the market investment like Mutual funds – Does it really compounds ?, Market does not gives you fix return, so why it says compound ? – read here to understand –