For the last few months, we’ve been conducting financial health seminars at companies in the Mumbai area. We hear a lot of users say – I don’t earn enough to save. What difference will saving Rs. 500 or Rs. 1000 a month make? It’s too little.
We can all relate to this sentiment. But it can limit us from realizing our savings potential. In this article, we will explore how starting early, even if it is a small amount, makes quite a difference to your savings success. This is because of a magical phenomenon called compounding.
Most of us have come across compounding in school. If you’ve repressed that traumatic memory, here is a quick reminder. The money you save or invest (called the “principal”) earns interest. That interest also earns interest in the future. This adds up over time to generate substantial gains.
Let’s do a fun exercise. Try your hand at the quiz question below.
Rs. 1 earning 6% compound interest for 50 years will become:
The answer is Rs. 3800. Over 50 years, Rs. 1 increases by 3,80,000%! This is probably why Einstein called compounding the eighth wonder of the world.
Let’s take a more real world example. One of our users is 23 years old. They said to us: “I can save only 500 rupees every month, but that seems so small”.
Saving Rs. 500 each month at 6% rate of interest would leave them with Rs. 34,885 in 5 years. That seems like a large sum for a few missed coffees every month, right? Saving does not mean that you need to miss out on the things you like – just make sure you are saving something, even small, that you are comfortable with.
To understand why time has this outsize impact, we need to look at the formula for compound interest.
A = P (1+i)^t
A = The final value
P = The principal, or initial saved amount
i = Rate of interest/return
t = time periods
You can see from the formula that the final value of the investment grows linearly with the principal sum. If the principal doubles, the final investment value also doubles. But the final value of the investment grows exponentially with time. At a 6% rate of interest, doubling the time period from 5 to 10 years, more than doubles the final investment amount. To 2.35 times the principal amount to be precise.
This is why we have a cardinal saying at Easyplan – Start early, even if you start small.
Of course, there is another important factor which is the rate of return or interest. That also makes a significant difference. However, that higher rate of return is also associated with risk. We will cover how to navigate the risk-return trade-off in future posts.