Compound interest accelerates the growth of your money by calculating interest not only on your initial principal but also on the accumulated interest over time. This process can lead to a snowball effect, where both your original investment and the earnings from it continue to grow together.
Investing in mutual funds comes with the power of compounding. However, most beginners may be confused about what compounding entails and how it is beneficial. Compound interest helps you earn returns on the invested funds as well as the interest accruing on the original investment.
In simple words, compounding helps grow your wealth faster. This article offers a comprehensive guide on compounding, outlining its benefits as well as highlighting strategies to maximise the benefits of compounding for investors.
What is compounding?
The benefits of compounding become clear when you understand its meaning. Compounding simply means earning interest on previously earned interest. In other words, the funds you initially invest generate earnings from the original principal amount and accrued interest earnings from past compounding phases. Compounding is different from simple interest calculations, where interest is computed solely on the principal sum. One of the chief benefits of compound interest is the steady growth of your corpus. The greater the number of compounding periods, the greater the compound interest growth. In India, several different investment avenues offer the advantage of compound interest. Strategic investment in such instruments can help grow your wealth faster.
How does compounding help to grow money?
Understanding the meaning and benefits of compounding is important for investors seeking to optimise their investments. As mentioned earlier, compounding helps your money grow faster since interest for each compounding period is calculated on the original principal sum as well as the accumulated interest earnings. In other words, it helps grow your money over time.
Let’s take an example to understand how your investments can benefit from compounding interest. Let’s say you invest Rs. 50,000 in an investment plan that offers you an annual return of 8%. At the end of the first year, your investment grows by Rs. 4,000. When the second year starts, your opening balance is Rs. 54,000. In the second year, your investment again grows by 8%. This time your corpus grows by Rs. 4,320 (8% of Rs. 54,000). This continues until the tenure of the investment ends or you withdraw the sum. Each year, the interest earned gets added to your opening balance which becomes the basis for compound interest calculations for the present year.
This demonstrates the power of compounding and how compound interest can benefit your investment returns, helping you achieve your long-term goals faster. It is important to note that the advantages of compound interest can be best experienced when you remain invested for a long tenure. Time is essential for your returns to compound. Therefore, the longer you stay invested, the greater the benefits of compounding.
Benefits of compound interest
The benefits of compounding are many and varied. Let’s have a look at some of the advantages of compound interest:
1. Your savings can grow faster
One of the primary benefits of compound interest is that it boosts your savings growth rate. Your interest earnings get reinvested into the original principal, generating additional returns. This snowball effect accelerates the growth rate of your corpus, helping you build wealth faster than simple interest income.
2. Long-term growth
The benefits of compounding are most visible when you remain invested for the long term. Your savings require time to compound since each compounding phase adds to your corpus. Therefore, the more compounding periods you have, the more wealth you can accumulate. This makes compounding a strategic tool for long-term financial planning. Starting early and staying invested for the long term can help you maximise the benefits of compound interest.
3. Reduces risk
Investors always seek investment instruments that can protect their funds from devaluation due to rising inflation levels. Compound interest earning is an excellent way to hedge against inflationary pressures. If your savings do not grow at the same rate as inflation, you face the risk of losing the real value of your saved funds. Inflation means a rise in the prices of goods and services, which indicates the diminishing purchasing power of money. Compounding at higher rates can help minimise the impact of inflation.
4. Encourages long-term planning
As mentioned earlier, the benefits of compound interest become apparent in the long run. This can encourage investors to undertake financial planning for the long-term horizon instead of simply focusing on their short-term needs. For instance, understanding the power of compounding can help motivate you to start saving and investing for your retirement while you are still in your 30s.
How does compounding benefit in long-term investment?
Compounding is a cornerstone principle for long-term investments. Compounding benefits long-term investments by generating returns on both the original principal invested as well as the accumulated interest from previous periods, thereby multiplying your initial investment exponentially over the long term.
Let’s say you are a 27-year-old investor who wants to start saving to buy a home. Accordingly, you invest Rs. 10 lakh for 10 years into an investment plan that offers a 10% interest compounded annually. In this case, you earn Rs. 1 lakh as interest in the first year, and your corpus stands at Rs. 11 lakh. However, at the end of 10 years, you would have earned Rs. 15,93,742 as interest, with your corpus value at Rs. 25,93,742. This demonstrates the benefit of compounding in the long run.
Formula for compounding
Now that you know all about the benefits of compounding, it's time to understand the formula used to compute compound interest. The compound interest formula takes both the original principal invested, the accrued interest into account, and the compounding frequency to compute the value of your investment.
The compound interest formula is listed below:
A = P(1 + r/n)^(nt)
Here,
A is the future value of your investment
P is the principal sum invested
r is the annual interest rate applicable
n is the number of times the interest is compounded every year
t is the total tenure of your investment
Strategies for maximising the power of compounding
Here’s a list of strategies that will help you maximise the power of compounding:
1. Start investing early
Starting early is the key to maximising the benefits of compound interest. The power of compounding works on the principle of time, so the earlier you start investing, the more time your funds have to grow.
2. Follow a disciplined approach
A disciplined investment approach with consistent contributions can further help maximise the benefits of compounding. To curate a robust portfolio, you should first identify your goals and invest with regular contributions to add to your principal sum. Additionally, a disciplined approach also means refraining from making premature withdrawals from your investment, as such withdrawals can eat away at your compounding benefits. Instead, you can build a separate emergency fund with liquid investments to prevent compromising your corpus growth.
3. Opt for investments with shorter compounding periods
The power of compounding also depends on the frequency at which the interest multiplies. Different investment instruments have different compounding frequency rates, including daily, monthly, quarterly, bi-annually, and annually. Try opting for investments with a shorter compounding frequency to maximise compounding benefits since increasing compounding frequency can boost returns. For instance, let’s assume there are two investment options, each offering a 7% compound interest. The first option compounds interest quarterly, while the second compounds interest annually. In this case, opting for the first option would be better since, here, interest is compounded 4 times a year, while the latter compounds just once every year.
4. Reinvest dividends and capital gains
When you invest in mutual funds or stocks, you stand to earn dividend income and capital gains. Instead of withdrawing these earnings, you should opt to reinvest them to maximise the compounding effect. The logic is simple: reinvesting your gains helps boost the principal amount, allowing your corpus to grow faster. For instance, let's say you start investing in mutual funds with SIP investments and opt for the dividend reinvestment plan. Here, the dividends you earn automatically get reinvested into the same mutual fund scheme and are used to purchase more MF units. Over the long-term horizon, your corpus will grow due to the compounding effect on the original investment, return on investment, and regular SIP contributions.
5. Invest in fixed returns schemes
Before you select investments to maximise the benefits of compounding, carefully evaluate your risk appetite. Some investment options, like stocks, have a proven track record of good compounding returns over the long term. However, they are also more susceptible to market volatility. If you are a low-risk investor, you can park your funds in fixed-return schemes like cumulative FDs that leverage the power of compounding to grow your corpus with guaranteed returns. If you want a risk-balanced approach, you balance your fixed-return schemes like FDs with a market-linked NPS Tier 1 account where interest is determined by the performance of the underlying asset.
Role of time in compounding
As mentioned earlier, time is a crucial component in reaping the benefits of compounding. Here’s how the advantages of compound interest depend on time:
Vitality of a long-term horizon
Investing for the long-term is crucial when you wish to maximise the power of compounding. The longer your investment duration, the more time your funds have to compound and grow. Each year you stay invested, your interest is added back to the principal and used to compute returns. This significantly enhances the overall growth of your corpus.
Effects on compound interest calculations
The compound interest formula takes the total time horizon into account. This means the longer your investment period, the better your returns, thanks to the power of compounding. Even small variations in the time horizon of your investment can change the returns due.
Using time as an ally
Time is your ally when you’re looking to harness the benefits of compound interest. An early start can give your investments time to grow and earn compounding returns. For instance, an investor in her 20s has more time to invest and maximise the growth potential of her investments compared to someone who starts investing at 50. Each year you delay investing is a year you miss out on the benefits of compounding.
Overcoming obstacles to compounding
There are several advantages of compounding when it comes to growing your wealth over time. However, as an investor, you must be mindful of the following factors that can compromise the power of compounding:
1. Impact of inflation
Inflation is the steady rise in the cost of goods and services. High inflation rates essentially erode the purchasing power of money and can potentially devalue your investment returns. Let’s assume the current inflation rate is 5%, and you invest in a cumulative FD that generates a return of 6%. While your returns may seem like 6% at face value, once you factor in the inflation rate, your real rate of return becomes just 1%.
2. High fees and taxes
Your investment returns can also be threatened by high fees and taxes, which can lower the benefits accruing from compounding. As an investor, you should be careful about the fees associated with the investment, like the expense ratio of a mutual fund or stock brokerage charges for equities. You should also undertake tax-efficient financial planning to make the most of tax deductions u/s 80(C). Several tax-saving instruments in India offer compounding benefits, including 5-year FDs, NPS, ELSS mutual funds, and others.
Conclusion
When it comes to building a wealth corpus, the power of compounding cannot be overstated. Recognising the benefits of compounding can help investors make sound choices. Understanding the effects of time, patience, and a disciplined approach can help you better harness the benefits of compound interest to grow your wealth and achieve your goals faster. By starting early, staying invested, and avoiding short-term impulses to withdraw, you can make the most of compounding returns.
Mutual funds can help you leverage the power of compounding while spreading investment risks. You can use the Bajaj Finserv Mutual Fund Platform to compare mutual funds, estimate returns using the mutual fund calculator, and start SIPs with a nominal sum of just Rs. 100. With a long-term perspective and disciplined approach, you can leverage the power of compounding to build a sizable wealth corpus.
