How Compounding Works Forward and Backward: A Guide by Tejas Joshi

Have you ever wondered why your investments grow exponentially over time or why loan repayments gradually become less burdensome? The answer lies in the principle of compounding, a powerful financial tool that works both forward and backward. Finance influencer Tejas Joshi shares insights on how compounding can either build your wealth through investments or reduce your liabilities when paying off loans.

Understanding how compounding works can help you make better financial decisions, whether you're saving for the future or managing debt.

Forward Compounding: How Investments Grow Over Time

In the context of investments, compounding allows your money to grow exponentially by reinvesting your returns. Here's how it works:
When you invest a sum of money, your principal earns returns each year.
These returns are added to your principal, creating a larger corpus.
The next year's returns are calculated on this increased amount, leading to exponential growth over time.
For example, if you invest ₹1,00,000 at an annual return rate of 10%, you earn ₹10,000 in the first year. By reinvesting this amount, your second-year returns are calculated on ₹1,10,000, not ₹1,00,000. Over time, this snowball effect can significantly increase your wealth.

Tejas emphasizes the importance of starting early with investments to maximize the power of compounding. The longer your money stays invested, the greater your returns due to compounding's cumulative effect.

Backward Compounding: How Loan Repayments Reduce Over Time

While compounding helps your investments grow, it works in reverse when you take out a loan. Here's what happens:

When you borrow money, you are charged interest on the outstanding loan amount.
As you make regular payments, both the principal and interest are reduced.
With each payment, the amount of interest decreases because it is calculated on a smaller principal.
For instance, if you take a loan of ₹5,00,000 at a 10% interest rate, your first payment includes a higher proportion of interest. However, as you continue repaying the loan, your principal decreases, and so does the interest you owe. Over time, your payments become more manageable because a greater portion of each installment goes toward reducing the principal.

Tejas advises borrowers to stay consistent with their loan repayments to take full advantage of this backward compounding effect.

Investment vs. Loan: The Power of Compounding

Tejas highlights an important takeaway: the same percentage rate of return behaves differently for investments and loans.
Investment: A 10% return on your investment leads to exponential growth due to forward compounding.
Loan: A 10% interest rate on a loan results in decreasing payments over time due to backward compounding.

This difference means that borrowing money at the same rate as your investment return is not equivalent. Investments generate long-term wealth, whereas loans decrease your liability gradually.

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Compounding is a double-edged sword. When used strategically through investments, it builds wealth exponentially. Conversely, when managing loans, it helps you reduce debt over time. As Tejas Joshi explains, understanding how compounding works both forward and backward can empower you to make smarter financial decisions.

By leveraging the power of compounding, you can grow your wealth while minimizing the burden of debt, leading to greater financial freedom.