1. What is Compound Interest?
The critical aspect of compounding is that it generates earnings on the previous earnings along with the base capital. The point is to build a broad base which keeps on adding to the past earnings. If you have Rs 1 lakh invested as an initial investment which is compounded at 10% per annum for the following 15 years, 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 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 in such a manner that they harness the power of compounding. As an investor, you will make gains when the value of each unit of investment goes up. When you make investments over a long time, the benefit of compounding helps you grow your investment. This is particularly the case in mutual funds because the money that is generated in the form of capital gains is reinvested to create additional returns.
You may choose to invest Rs 1,000 every month in a mutual fund for the next ten years and at a rate of 8% per annum. So, you will notice that your investment of Rs 1,20,000 in 10 years gave you a return of Rs 1,82,946. Now if you choose to invest it further for say another ten years, the money now reinvested will grow even faster and give you Rs 3,94,967. This is the unique thing about compounding where the existing investment, along with the returns on this investment and the new investment each month, all contribute towards further gains.
|Power of compounding on investment of ₹1 lakh a year for 5 years|
|Year||Opening balance (₹)||Investment (₹)||10% interest (₹)||Closing balance (₹)|
|Total investment: ₹5,00,000 | Value after 5 years: ₹6,71,561 | Interest earned: ₹1,71,561|
If there was no compound interest, your total investment of ₹5 lakh would have earned you ₹50,000 at 10% interest. The difference made by compounding is worth ₹1,71,561 in the above example. That’s almost 3.43 times more than you have earned.
3. What Are the Key Rules of Investment That Enable Compounding?
a. Make an early start
There is nothing like you need to start early to make the most of compounding. If you start investing from the time you start earning, it will make for a solid base that will enable your funds to grow further over time.
If you wish to create a healthy portfolio, 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, will help you develop the habit to keep funds aside for investing.
c. Be patient
A lot of us wish for quick returns, not realizing that it is the long-term investments that powerfully reap from the concept of compounding. You will have to allow your investment to grow at its own pace without meddling with it. Years of dedicated investment on your part will render a healthy and robust lump sum amount for you at the end.
d. Check your spending
Saving is a habit that all of us must inculcate, but more important than that is knowing where to spend your money. It is not a difficult chore to develop a plan and then focus on it. Budgeting is essential to ensure that you are never caught off guard and that you have the means to fend for yourself. If you spend wisely, you will reap well.
|If you begin investing Rs 1 lakh a year and increase your investment by 10% every year, then this is how compounding interest will help your money grow|
|Year||Opening balance (₹)||Investment (₹)||10% Interest (₹)||Closing balance (₹)|
|Total investment: ₹6,10,510 | Value after 5 years: ₹8,05,255 | Interest earned: ₹1,94,745|
4. How Much Should I Invest to Achieve My Financial Goals?
There are calculators available online where you can quickly evaluate how much money you would require saving 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.