Power of Compounding – How Can Compound Interest in Mutual Funds Make You Rich?
Updated on: Jun 28th, 2022
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2 min read
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.
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 that 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 keeps 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 withdrawal of profits will not let the base of the investment grow to a more significant sum.
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;
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
How Much Should I Invest to Achieve My Financial Goals
There are calculators available online where you can quickly get to know how much savings is needed to achieve a given goal. 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 handpicked 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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Quick Summary
Compounded interest occurs when interest is earned on previous interest, leading to significant wealth accumulation over time. This is evident in mutual funds investments. Compounding reinvests earnings to generate further profits. It's essential to reinvest earnings to grow the investment. Calculations can help determine the amount needed to achieve financial goals.
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