Thinking in terms of Compound Interest
I just gave you 1 crore rupees. You lucky You!!!
Now I put a gun to your head and ask you to choose one among these 3 investment options that gives you the highest rate of return.
Option 1
You invest 1 cr in an instrument that after 10 years, pays you Rs 25 Lac p.a for the next 10 years
Option 2
You book a 1 cr cumulative fixed deposit that gives you 7.2% p.a for the same tenure
Option 3
You buy some real estate that triples your investment over the same tenure i.e 3 crores
Which one would you choose?
Option 1 is paying you back 25 Lac yearly income*10 years=2.5 Cr total payout
Option 2 is a Cumulative FD with 7.2 % p.a return which you can withdraw only at the end of tenure
The third and the most popular option gives you a whopping 3 Cr at the end of tenure
The Choice
If you chose option 2, you can stop reading this post and carry on with your day
But If you’re like the rest of us and chose either options 1 or 3, let me explain what you missed
The Effect of “Compound Interest” over 20 years
The Compound Interest Formula
Compounded Annual Growth Rate (CAGR)=((Final Value/Beginning Value)^(1/Time)-1)
This is nothing but the rate at which interest on interest is accumulated over the tenure
The Numbers
Option 1 is giving you a internal rate of return(IRR)equal to 6.65% p.a (Calculated using IRR function of excel,IRR=CAGR in this case)
In Option 3, Even though your money is tripled the actual compounded growth rate is just 5.65% p.a
So 7.2% of option 2 is just 0.55% more than option 1 and 1.55% more than option 3
What difference does 0.55% or 1.55% really make?You may ask
The Difference
A Return of 7.2% p.a compounded over 20 years takes your 1 Cr to a maturity value of Rs 4.01cr i.e 4 times your initial investment!!!
How does it work?
Year | Accumulated Amount at Year End @7.2% p.a |
1 | 10720000 |
2 | 11491840 |
3 | 12319252 |
4 | 13206239 |
5 | 14157088 |
6 | 15176398 |
7 | 16269099 |
8 | 17440474 |
9 | 18696188 |
10 | 20042314 |
11 | 21485360 |
12 | 23032306 |
13 | 24690632 |
14 | 26468358 |
15 | 28374079 |
16 | 30417013 |
17 | 32607038 |
18 | 34954745 |
19 | 37471486 |
20 | 40169434 |
Notice that it takes
10 years for 1 cr to become 2 cr
6 years for 2 cr to become 3 cr
And Just 4 years for 3 cr to become 4 cr i.e you earn approximately 25 Lac p.a in these 4 years
The last few years is where the magic happens,your money grows in value much faster!!!
Summary
Even though we are not naturally wired to do so,Thinking in terms of compound interest for all your major financial decisions will have a huge impact on your long term wealth
So Invest for the long term, let your money compound and wait till the end!!!
Which option did you choose?Let me know in the comments below
Please subscribe here to get my latest posts delivered straight to your inbox.
GOOD
Thank You