The power of compounding refers to the ability of an investment to generate earnings not only on the original principal amount, but also on the accumulated interest earned over time.
There are multiple investment options where the power of compounding is used and the interest earned is credited on your invested funds. These investment plans typically feature a clear compounding period, such as yearly, monthly, or even daily, allowing you to take advantage of compounding as needed. One of these investments is fixed deposit. Before we learn about how power of compounding impacts fixed deposit, let us know about the power of compounding.
What is the power of compounding?
The power of compounding works by multiplying your wealth tremendously. To speed up the process of earning profits, it adds the profit made back to the initial sum before reinvesting the complete total.
In essence, the power of compounding is the act of "adding interest on interest," meaning that the amount of money you invest will result in returns from both the initial capital and the collected earnings from earlier compounding periods. So, the force of compounding eventually aids in the gradual growth of your wealth.
For example, if you invest Rs. 1000 and earn a 10% annual return, in the first year you will have Rs. 1100. If you leave the Rs. 100 of interest earned in the account and continue to earn 10% per year, in the second year you will earn Rs. 110 (10% of Rs. 1100) in interest. By the end of the second year, you will have Rs. 1210.
This process continues, with the interest earned in each period also earning interest in the following periods. The longer the investment is left to compound, the greater the potential returns.
How the power of compounding works in investments?
The power of compounding is something that can build generational wealth with just a small initial investment. It is one of the most powerful forces in investing, and it can turn a small investment into a large sum over time. Whether it is a safe investment option like a fixed deposit or the Systematic Investment Plan (SIP), both work on the power of compounding.
Here, the interest is first accrued on the initial deposit amount then eventually as tenure progresses the initial deposit amount increases as the initial deposit is now considered as principal amount plus interest accrued.
The power of compounding is the ability of an asset to generate earnings, which are then reinvested to generate their own earnings. This process can be illustrated with the use of fixed deposit and mutual funds.
Example of Power of Compounding
Here’s an example of a better understanding of the power of compounding:
If you invested Rs. 1,00,000 and at 10% p.a., you will earn an interest of Rs. 10,000 at the end of the first year. Then in the next year, you’ll end up earning an interest of Rs. 21,000 instead of Rs. 20,000, and so on.
The formula for Compound Interest
There is a simple formula in which you can calculate compound interest that is, sum of the amount of principal and interest – the principal amount at present.
P(1 + r/100)n – P
Where, P is the principal amount, n is the number of years, and r is the rate of interest.
Add example of let’s say a person called XYZ invested Rs. 1,00,000 for 5 years at 10% p.a. returns.
- Scenario 1: The interest earned is withdrawn every year.
At the end of 5 years XYZ will end up earning an interest of Rs. 50,000.
- Scenario 2: The interest gets added back to the principal amount every year.
At the end of 5 years XYZ will end up earning an interest of Rs. 61,051.
This clearly shows the power of compounding.
How does the compounding work in a fixed deposit?
Fixed deposits are safe investment options that offer
profitable returns. With Bajaj Finance you can invest in a fixed deposit with just Rs. 15,000. It offers customers an investment tenure of 12 to 60 months and the interest rate also varies during this tenure.
Check the latest FD rates.
There are two types of fixed deposit:
Cumulative fixed deposit: In this the interest is compounded annually and the principal amount along with the interest is paid at maturity.
So, every year the interest you earn on your deposits, gets added to the principal amount, which then becomes the principal amount for the next year.
Non-cumulative fixed deposit: These plans pay interest on a monthly, quarterly, half-yearly, or yearly basis. The interest in this case is paid to the investor on a periodic basis, whereas the principal amount is paid at maturity.
The effect of compounding can be significant over the long-term, particularly for investments with a high rate of return and a long investment horizon. For example, if you invest Rs. 1,00,000 in a fixed deposit with an annual interest rate of 7% for 5 years, the total amount you would receive at maturity would be Rs. 1,40,260. However, if the interest is compounded annually, the total amount you would receive at maturity would be Rs. 1,40,710, which is an additional Rs. 450 due to the power of compounding.
It is important to note that the interest rate, compounding frequency, and investment horizon are all important factors that can impact the power of compounding in fixed deposits. Therefore, it is essential to carefully consider these factors when selecting a fixed deposit to ensure that you maximise the benefits of compounding.
What is the Power of Compounding in Mutual Funds?
The power of compounding can work wonders in mutual funds, potentially helping investors achieve their financial goals faster.
In mutual funds, investors can harness the power of compounding through Systematic Investment Plans (SIPs). With an SIP, investors can invest a fixed amount at regular intervals, such as monthly, quarterly or semi-annually, which is then invested in the fund of their choice. The returns earned on these investments are then reinvested back into the fund, allowing the investor to take advantage of the compounding effect.
Over time, this compounding effect can lead to significant growth in the value of the investment.
For example, let's say an investor starts an SIP of Rs. 5,000 per month in an equity mutual fund with an assumed average annual return of 12%. After 10 years, the investment would have grown to approximately Rs. 12 lakhs, with the investor having invested a total of Rs. 6 lakhs over the 10-year period. However, if the investor had not reinvested their returns and simply withdrawn them, the investment would have grown to only around Rs. 9 lakhs, representing a significant difference in returns.
Mutual funds provide a great avenue for investors to take advantage of the power of compounding through regular investments using SIPs. By reinvesting returns and staying invested for the long-term, investors can potentially achieve their financial goals faster and generate higher returns over time.
What are the advantages of compound interest?
Compound interest has several advantages, including:
1. The ability to earn interest on both the original principal and the accumulated interest.
2. The potential for significant growth over time.
3. The ability to compound interest on a regular basis, which can accelerate growth.
4. It can be a powerful tool for building wealth and reaching long-term financial goals.
5. It also can be used to grow savings for retirement, education, and other expenses.
Key rules of investment that enable the power of compounding
Here are some key rules that can help enable the power of compounding in investments:
- Start investing early: The earlier you start investing, the more time your money will compound and grow.
- Invest regularly: Setting up a regular investment plan, such as a monthly or annual automatic investment, can help ensure that you are consistently putting money into your investments.
- Invest for the long-term: The power of compounding is most effective over long periods of time, so it is important to have a long-term investment horizon.
- Diversify your investments: Diversifying your investments across different asset classes and sectors can help reduce risk and improve returns.
- Invest in high-growth assets: Investing in assets that have the potential for higher returns, such as stocks, can help increase the power of compounding.
- Be patient: The power of compounding takes time to work, so it is important to be patient and not make impulsive decisions based on short-term market fluctuations.
- Avoid unnecessary fees: High fees can eat into your returns and decrease the power of compounding, so it is important to choose low-cost investment options.
In conclusion, the power of compounding can be leveraged in both fixed deposit and mutual funds to generate substantial returns over time, but mutual funds have the potential to generate higher returns as they are invested in a diversified portfolio of securities, which have the potential to grow faster.
In case of compounding, the reinvested earnings can accumulate and compound to create significant growth in the original investment. The power of compounding works in a way where the interest is initially applied to the principal amount and in the subsequent years, it keeps multiplying as the initial amount keeps increasing.
The effect of compounding is dependent on the rate of return and the frequency at which the returns are reinvested. The longer the investment is held and the higher the rate of return, the greater the power of compounding.