In Mathematics, simple interest is the amount earned on the principal amount. When the principal amount also keeps on increasing year after year on addition of interest, it is called compound interest. Similarly, in financial terms, the power of compounding is the increase in the value of an investment over time due to interest and the same interest is added back to the principal amount. So instead of spending the earnings, you reinvest it to earn more interest.
The power of compounding is essentially used to grow your wealth exponentially. Suppose, you invest Rs. 1000 in a bank which offers 10% interest per annum. Your investment becomes Rs 1100 after the first year, then Rs 1210 after 2nd year and so on. So over a course of time, your investments and savings show substantial growth.
In whatever form you save your money (either in a savings account, mutual funds or in individual stocks), if it is compounded annually, higher interest is earned on bigger and bigger pools of money. And there is no extra effort required. Whatever is surplus should be kept aside, if not in one go then periodically.
How does this work?
Suppose you invest Rs. 1 lakh every year, in an investment plan that offers a 5% compounding interest annually. At the end of 5 years, your total investment of Rs. 5 lakhs would be worth Rs 5.80 lakhs. If the rate of return increases to 8%, the future value will grow to Rs. 6.34 lakhs.
Key Takeaways of compounding
Reinvestment - The interest earned will be reinvested into the same deposit.
Higher value of the deposit - Compound interest leads to a higher value of the deposit. Upon maturity, your deposit will be more than a deposit with simple interest.
Long-term savings - Compound interest deposits encourage long-term savings as the return on investment is much higher after 10 years or more.
Increased Earnings - Options of compounding monthly, quarterly, and half-yearly increase the interest earned.
Financial instruments where compounding is applicable:
You can reap compounding benefits from a variety of investment options in India including fixed-income and market-linked instruments like mutual funds.
Savings Accounts- Since the savings account in your bank holds a certain sum and the yearly interest that is given gets added to the last balance, you cannot be sure of the earnings that you make as you are spending from it.
Recurring Deposits- When you fix a certain amount that goes into a recurring account in your bank, the interest earned at the end of the term can be used or reinvested. Though some amount of compounding is there, the rate of interest is not much as the period is usually small and the returns are limited as it is not linked to the market and the interest gets fixed at the time of initiation.
· Fixed Deposits- If you want to make earnings from interest offered by the safer option of banks and don’t wish to enter the riskier stock market, then fixed deposits are the best bet. Since the period is fixed, you can earn better than both saving and recurring deposits; still the rate of interest being fixed, the returns are lower than the market-linked options.
· Mutual Funds- Growth Mutual Funds reinvest the yields from the underlying scheme. Interest is compounded monthly, quarterly, or half-yearly, depending on the Mutual Fund scheme. These are designed in such a way so as to magnify the benefits of compounding. This is possible through Systematic Investment Plans (SIPs). You can invest a fixed amount regularly through SIP and you can automate your payments by giving a standing instruction to your bank.
· Unit-Linked Insurance Plans (ULIPs)- A Unit Linked Insurance Plan (ULIP) is a unique investment instrument with the added protection of life insurance. Through systematic investments and market-linked returns, ULIPs allow you to create wealth for your long-term goals like your dream house, your child's education, your retirement and more.
While keeping the risk at bay and time horizon in mind, you can maximise the effect of the power of compounding. You can choose a combination of these and many others for achieving your goals of wealth creation, security, surety and financial freedom.
Capitalise on the magic of Compounding