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Compounded interest is the interest earned on interest. Compounded interest leads to a substantial growth of your investments over time. Hence, even a smaller initial investment amount can fetch you higher wealth accumulation provided you have a longer investment horizon of say five years.

  1. What is Compound Interest?
  2. How Does Compounding Occur in Mutual Funds?
  3. What Are the Key Rules of Investment That Enable Compounding?
  4. How Much Should I Invest to Achieve My Financial Goals?

 

1. What is Compound Interest?

The most significant aspect of compounding is that it offers interest on the previously earned interest along with the base capital. The whole idea of compounding is to build a broad base which keeps on adding to the previous earnings. If your initial investment is Rs 1 lakh and is compounded at the rate of 10% per annum for the next 15 years, then you will have a base of Rs 4,17,725. This is how compounding creates a cycle of earnings that keep growing.

As an investor, keep in mind that the crucial point of compounding is that the earnings generated by the investment should be reinvested. One must not, at any point, withdraw their returns. This withdrawing of profits will not let the base of the investment grow to a more significant sum.

 

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As an investor, keep in mind that the pivotal point of compounding is that the earnings generated by the investment should be reinvested. One must not, at any point, withdraw or take the returns. This withdrawing of profits will not let the base of the investment to grow.

2. How Does Compounding Occur in Mutual Funds?

Mutual funds are designed to make the most out of the power of compounding. Investors gain when the value of fund units goes up. If you invest with a long-term horizon, then the power of compounding will be unleashed to the fullest, which helps you grow your investment. This is particularly the case in mutual funds as the returns generated in the form of capital gains are reinvested to create additional profits.

If you choose to invest Rs 1,000 a month in a mutual fund scheme for the next ten years, and if the rate of return is 8% per annum, then you will notice that your investment of Rs 1,20,000 in 10 years will yield you a profit of Rs 1,82,946. Now if you choose to invest it further for say another ten years, then money now reinvested will grow even faster to fetch you Rs 3,94,967. A unique feature of compounding is that your existing investment, along with the return on investment and the new investment each month, all contribute towards further gains.

Example:

 

Power of compounding on investment of Rs 1 lakh a year for 5 years

Year

Opening balance (₹)

Investment (₹)

10% interest (₹)

Closing balance (₹)

1

1,00,000

10,000

1,10,000

2

1,10,000

1,00,000

21,000

2,31,000

3

2,31,000

1,00,000

33,100

3,64,100

4

3,64,100

1,00,000

46,410

5,10,510

5

5,10,510

1,00,000

61,051

6,71,561

Total investment: Rs 5,00,000 | Value after 5 years: Rs 6,71,561 | Interest earned: Rs 1,71,561

If there were no compound interest, then your total investment of Rs 5 lakh would have earned you Rs 50,000 at 10% interest. The difference made by compounding is worth Rs 1,71,561 in the above example. That’s almost 3.43 times more than what you have earned with compounded interest.

 
Compounding fund

3. What Are the Key Rules of Investment That Enable Compounding?

a. Make an early start

Starting early to invest is the key to making the most out of the power of compounding. If you start investing from the time you start earning, then it will make for a solid base that will enable your funds to grow further over time.

b. Discipline

If you wish to create a healthy portfolio, then you must define your priorities and be regular in your investments. Regardless of how less you earn, knowing what your preference is and understanding how being disciplined now would pay off later, this will help you develop the habit to keep funds aside for investing.

c. Be patient

A lot of investors would like to have quick returns, not realizing that it is the long-term investments that powerfully reap from the concept of compounding. You will have to give your investment some time to grow to a significant sum.

d. Check your spending

Every individual should inculcate the habit of saving. Also, investors should know where they need to spend their money. This is when budgeting becomes essential as it ensures you tracking your expenses. If you spend wisely now, then you will reap better later.

Example:

 

If you begin investing Rs 1 lakh a year and increase your investment by 10% a year, then this is how compounded interest helps your money grow:

Year

Opening balance (₹)

Investment (₹)

10% Interest (₹)

Closing balance (₹)

1

1,00,000

10,000

1,10,000

2

1,10,000

1,10,000

22,000

2,42,000

3

2,42,000

1,21,000

36,300

3,99,300

4

3,99,300

1,33,100

53,240

5,85,640

5

5,85,640

1,46,410

73,205

8,05,255

Total investment: Rs 6,10,510 | Value after 5 years: Rs 8,05,255 | Interest earned: Rs 1,94,745

 

 
Compounding fund

4. How Much Should I Invest to Achieve My Financial Goals?

 

There are calculators available online where you can quickly evaluate how much saving is required if you wish to reach a specific target. The tools available online give you the particular figures based on how much time you want to compound for, the rate of interest offered, and so on.
To know more about where you can invest to meet your financial goals, visit ClearTax and choose from our select offerings of funds.
    

To know more about where you can invest to meet your financial goals, visit ClearTax and choose from our select offerings of funds.

 

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