What is compounding interest? How compounding interest works?

 Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest. Compound interest is standard in finance and economics.

This is the explanation given in internet. Now, let us understand it more deeply.

Compound interest has both principal amount and interest for an year earned interest in the next period. The value of money here is the foundation of the compound interest. More than one compounding period in a year can be there. 

Compounding is the process in the overall value of an investment will rise as the interest on the investment and with each passing day it's principal interest earned will be rising. With the help of compounding interest one can witness the increase in the overall value of their investment.

Let's take an example and see how compound interest works:- 

Suppose a company called ABC has put in its INR 1, 00,000 in an investment which gives 20% return annually (using compound interest rate) then this is how much the company will earn in the first two years:

First year: Rs. 1, 00,000 (Principal amount) + Rs. 20,000 (Interest earned by the end of first year) = Rs. 1, 20,000

Second year: Rs. 1, 20,000 (Principal amount) + Rs. 14,000 (Interest at the end of the second year) = Rs. 1, 340,000

 This is a simple example  showed with calculation that how compound interest helps to grow money .

Compound interest takes into account the time value of money and it depends on an individual. For every individual Value of money changes depending upon how much he receives it. Suppose , if you earn today Rs. 10000 it's better than earning the same amount 5 years back from now.

The concept of compounding interest is undoubtedly beguiling and one would want to earn higher returns at every cost. 

The investor must understand that apart from the interest he earns on the principal amount, the length or the time period of your investment is also significant. The longer you keep your money untouched, the bigger would be your pay out. It proportionately implies to the saying, " the longer you wait, the more you gain". 

Now, what is the power of compounding? 

The power of compounding works by growing your wealth exponentially. It will add the profit earned back to the principal amount and then reinvests the entire sum to accelerate the profit earning process.

Let's again understand this with an example:-

Suppose, you invest ₹ 2000 in a bank which offers 10% interest per annum. Your investment becomes ₹ 2100 after the first year, then ₹ 2210 after 2nd year and so on.

As already quoted by Albert Einstein," Compound interest is the eighth wonder of the world. He who understands it, earns it...he who doesn't...pays it".

 

Compound interest is also said as the strongest force in the universe.

Compound interest will never leave you in loss . One just need to understand it and follow according to its rule. 

Compound interest will always double the amount you invest today for an estimated period .

Even Buffet, Warren Buffet, everyone has heard about him. Buffet bought his first stock at the age of 11, he himself uses this compound interest formula. 

Warren Buffet said,"My wealth has come from a combination of living in America, some lucky genes, and compound interest."