Albert Einstein is quoted as saying “Compound interest is the 8th Wonder of the World. Those that understand it, earn it. Those that don’t, pay it.”
Imagine you receive some cash as a birthday gift. If you plan to use this money for a large purchase in the future, you could do a few things. First, you could just place it in a safe spot in your house. When you need this cash in the future, it will be there for you. An alternative to this is that you could deposit this money in the bank. This deposit is also known as the ‘principal’. By doing so, you will receive interest on this principal.
With the interest you earn, you have a choice. Whenever the interest is paid, you could withdraw it and place it in the safe spot in your house while still keeping the original principal in the bank. This is simple interest – you are earning only interest on the principal.
You could also just leave the interest you earned in the bank. By doing this, the future interest that the bank pays you will be based on both your original amount as well as the interest that the bank previously paid you. This is compound interest – you are earning both interest on the principal and interest on interest.
Here is a quick example. You start out with ₹1,000 and you either:
- Keep it in ‘cash’ and don’t invest
- Invest but don’t reinvest the interest earned (simple interest)
- Invest and reinvest the interest earned (compound interest)
Assuming you earn an average interest rate of 12% for 30 years, your ₹1,000 initial investment turns into nearly ₹30,000 through compound interest.
Over time, there can be exponential differences between simple interest and compound interest. One way to think about compound interest is that your money is working for you while you sleep. The more time you allow your money to work for you, the easier it will be for you to reach your retirement goals.